Duncan Weldon says:
Many of the supposed supply constraints the UK economy currently faces are actually related to problems on the demand side of the economy. Boosting demand now would boost productivity.
But Duncan's hypothesis can be tested. Why not boost demand and find out?
Herein, I fear, lies a problem with the inflation target.Taken literally, it penalizes avoidable inflation, but not avoidable unemployment.It thus rules out taking the risk of raising inflation, but permits the risk of tolerating what, if Duncan's right, would prove to be unnecessarily weak demand.
This bias is absurd.People hate (pdf) unemployment as well as inflation.So, surely, unemployment should have a weight in the policy target - as it has in the US.
Now, this absurdity was not supposed to arise. If you think the economy is buffetted only by demand shocks, there's no trade-off between targeting inflation and unemployment: when demand's weak, inflation is expected to fall and so policies that boost demand and cut unemployment are compatible with the inflation target.
However, when the economy is hit by supply shocks or by shocks that we can't easily identify as demand or supply ones then the trade-off does emerge.
This suggests a case for targeting nominal GDP. Doing so recognizes what should be obvious - that unemployment matters as well as inflation.
One counter to this is that such a target doesn't recognize the difference between real and nominal growth. It is indifferent between 5% inflation and zero real growth and 5% real growth and zero inflation.
I'm not convinced by this. If nominal GDP is growing by (say) 5% a year, we can say that monetary policy is doing its job. If the growth-inflation split is undesireable, then the answer lies in supply-side policies to improve that split, not necessarily in tighter monetary policy*.
Instead, my scepticism about NGDP targeting is that I'm not sure it would be much different from what we've had; if you've got no gun, it doesn't much matter what your target is.
And, remember, monetary policy isn't the only weapon we have. You can, y'know, boost demand by fiscal policy.
* The counter-objection to this is that if high inflation expectations become embedded then it's costly to get them down, but this is another story.