Nominal GDP growth targeting vs. Taylor rules in a model with financial frictions

Nominal GDP growth targeting has gained favor over the last few decades in monetary policy literature (e.g., Ireland 2020; Garín et al. 2016; Beckworth and Hendrickson 2020). Calibrated, small-scale New Keynesian DSGE models have supported the proposition that nominal GDP growth (NGDP growth) rate targeting will improve welfare as compared with alternative strategies such as inflation targeting and Taylor rules with standard parameter settings. This paper examines that proposition in the context of a medium-scale New Keynesian model having a financial sector with frictions. In that model, NGDP growth rate targeting does poorly as compared with the Optimal Taylor rule and a wide range of Taylor rule settings leading up to the Optimal (representative agent utility maximizing) Taylor rule. The presence of the financial sector reveals that not only is NGDP growth rate targeting the least successful among the alternative targets and rules in creating welfare in this model; NGDP growth rate targeting also creates dramatically higher volatility of the policy rate and most financial variables. •Financial frictions reduce the efficacy of nominal GDP growth rate targeting.•Many Taylor rules outperform nominal GDP growth rate targeting in enhancing welfare.•Nominal GDP growth rate targeting increases policy rate and financial variable volatility.•A collateral constraint amplifies the superiority of the Optimal Taylor rule.•Inflation targeting induces higher financial variable volatility than Taylor rules do.