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In this paper, we analyze the relationship between nominal and real GDP growth for G7 countries for the period 1971 – 2018. A visual inspection of the data indicates the presence of a threshold, above which the structure of the relationship between nominal and real GDP growth rates changes from a positive one to a flat one. Moreover, the volatility of real growth is observed to be higher at high rates of nominal GDP growth. We first test for the presence of a two regime non-linearity by using the Sup F test of Andrews (1993). Due to the presence of heteroskedasticity we also apply the Sup MZ test of Ahmed et al. (2017). Both tests operate under an unknown change point and the latter also allows for heteroskedasticity. The results of the tests point to the presence of a ‘demand deficiency ’regime for low nominal demand growth rates and to a ‘harmful inflation ’regime for higher nominal GDP growth rates, these results have strong implications for guiding recent policy discussions on nominal GDP targeting.

We study optimal monetary policy at the zero lower bound. The macroeconomy we study has considerable income inequality which gives rise to a large private sector credit market. Households participating in this market use non-state contingent nominal contracts (NSCNC). A second, small group of households only uses cash and cannot participate in the credit market. The monetary authority supplies currency to cash-using households in a way that changes the price level to provide for optimal risk-sharing in the private credit market and thus to overcome the NSCNC friction. For sufficiently large and persistent negative shocks the zero lower bound on nominal interest rates may threaten to bind. The monetary authority may credibly promise to increase the price level in this situation to maintain a smoothly functioning (complete) credit market. The optimal monetary policy in this model can be broadly viewed as a version of nominal GDP targeting.

Financial markets are incomplete, thus for many households borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating households' nominal incomes from aggregate real shocks, this policy effectively completes financial markets by stabilizing the ratio of debt to income. The paper argues the objective of replicating complete financial markets should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.