From Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting, by Kevin Sheedy (LSE), presented at the NBER Summer Institute:
This paper has shown how a monetary policy of nominal GDP targeting facilitates efficient risk
sharing in incomplete financial markets where contracts are denominated in terms of money….
environment where risk derives from uncertainty about future real GDP, strict inflation targeting would lead to a very uneven distribution of risk, with leveraged borrowers’ consumption highly exposed to any unexpected change in their incomes when monetary policy prevents any adjustment of the real value of their liabilities. This concentration of risk implies that volumes of credit, long term real interest rates, and asset prices would be excessively volatile. Strict inflation targeting does provide savers with a risk-free real return, but fundamentally, the economy lacks any technology that delivers risk-free real returns, so the safety of savers’ portfolios is simply the
flip-side of borrowers’ leverage and high levels of risk. Absent any changes in the physical investment technology available
to the economy, aggregate risk cannot be annihilated, only redistributed.
That leaves the question of whether the distribution of risk is efficient. The combination of
incomplete markets and strict inflation targeting implies a particularly inefficient distribution of
risk when individuals are risk averse. If complete financial markets were available, borrowers would
issue state-contingent debt where the contractual repayment is lower in a recession and higher in
a boom. These securities would resemble equity shares in GDP, and they would have the effect
of reducing the leverage of borrowers and hence distributing risk more evenly. In the absence of
such financial markets, in particular because of the inability of households to sell such securities,
a monetary policy of nominal GDP targeting can effectively complete the market even when only
non-contingent nominal debt is available. Nominal GDP targeting operates by stabilizing the debt to-GDP ratio. With financial contracts specifying liabilities fixed in terms of money, a policy that
stabilizes the monetary value of real incomes ensures that borrowers are not forced to bear too much
of the aggregate risk, converting nominal debt into real equity.