## OPEN-ECONOMY MARKET: Nominal Income Targeting

In this section we estimate a specification closely related to CGG’s, and compare it to a specification in which policy responds to expected nominal income growth instead of expected inflation. Our version of CGG’s (1997) specification is as follows:

with рл e(0,l) and ewhite noise. Here 4Rt and 4Apt are the annualized values of the federal funds rate and the log-change in the GDP deflator, and ut is the unemployment rate (expressed as a fraction). There are two differences in specification (3.1) from CGG’s baseline model. First, we use utto measure the output gap, whereas CGG’s unemployment-based measure of the output gap was the detrended unemployment rate. (We also obtained estimates using detrended W/). Secondly, we add D7982t, a dummy variable taking the value 1.0 during the “new operating procedures” period 1979:4-1982:2, to the equation. We include this variable because we found in our earlier estimates of the Fed’s policy rule (McCallum and Nelson [1998]) that it entered significantly.

Apart from our inclusion of D7982t, our instrument list is the same as in CGG: a constant term, and lags 1-4 of inflation, the federal funds rate, the 10 year bond / funds rate spread, the unemployment rate, commodity price inflation (from the Producer Price Index), and М2 growth. Our data were downloaded from the Federal Reserve Bank of St. Louis’ FRED database, and our estimation period is 1979:3-1997:3.

The first column of coefficients in Table 1 reports our estimates of equation (3.1), which is closely related to CGG’s specification. In the second column, we replace expected next-period inflation in (3.1) with expected next-period nominal income growth, Ем Ax/+1. The residual standard error declines slightly relative to the fit of (3.1). Moreover, the New Operating Procedures dummy becomes significant (its t-value rises from 0.81 to 3.79) and the estimate of the output gap response coefficient, фgap , is five times larger and is much more precisely estimated. CGG’s result that the policy response to the output gap is insignificant after 1979 thus appears sensitive to the specification of the nominal aggregate to which policy reacts —inflation or nominal income growth. online payday loans direct lenders only