Monetary Policy Strategy in Rwanda

2.3.2.3 Nominal GDP Target Rule

The lost of reliability of monetary supply as a policy rule, led economists to think that nominal GDP targeting might be a good fundamental guide for policy. The idea argued that Central Bank should target nominal GDP using one of several policy rules. Such a rule would specify how the Central Bank should adjust to affect a short-tem interest rate in response to deviations in nominal GDP from target (Clark, 1994).

One of the most important reasons why the monetary aggregates rule is less reliable is nothing more than the fact that its relationship with prices and output have deteriorated, apparently in response to financial deregulation and innovation (Judd and Trehan, 1992 as quoted in Judd and Motley, 1993).

The way the nominal GDP targeting rule works can be explained as follows:

«Under this rule, the Central Bank announces a planned path for nominal GDP. If nominal GDP rises above the target, the Central Bank reduces money growth to limit aggregate demand. If it falls below the target, the Central raises money growth to stimulate aggregate demand» (Mankiw, 2000:397).

Mathematically, Judd and Motley (1993) explained a simple way to calculate the channel of influence from nominal GDP growth to inflation. The following is the detail of their explanation:

(1) ?P = ?X - ?Y where ?P, ?X, and ?Y represent the annualized growth rate of the implicit GDP deflation, nominal GDP, and real GDP, respectively. The formula states that inflation is equal to the difference between growth in nominal and real GDP. In the long-term, real GDP growth can be approximated by a trend rate that is determined by real factors including the growth in labour, capital, and productivity, and thus is largely independent of nominal GDP growth. The result of this is that, any given growth rate of nominal GDP can be translated into a corresponding inflation rate in a simple way. The example mentioned is that trend (or potential) real GDP growth is commonly estimated at around 2%, so that a 5% growth rate of nominal GDP would fix long-term inflation at around 3%. Judd and Motley(1993) proposed in the same sense that:

«Since the growth rate of nominal GDP is equal to the growth rate of money (?m) plus the growth rate of velocity (?V), targeting money can be seen as an indirect method of targeting nominal GDP» (Judd and Motley, 1993: 4).

(2) ?X = ?m +?V

Putting these definitions together yields:

(3) ?P = ?m + ?V - ?Y

As long as trend velocity growth is stable, any given long-term growth rate of money can be translated into a long-term inflation rate in a straightforward manner. When the velocity of M₂ was stable, the relationship between M₂ and inflation was particularly simple, since historically, the trend growth rate of M₂ velocity was zero. Thus, for example, a 5% growth rate of M₂ would produce a 5% nominal GDP growth and a 3% rate of inflation in the long run. However, when the velocity is unstable, direct nominal GDP targeting has the advantage that it is not adversely affected by unpredictable swings in velocity. In effect, nominal GDP targeting is a way to circumvent problems with the velocity of money in conducting monetary policy.