Published online by Cambridge University Press: 12 March 2018
Benhabib and Farmer show that in a laissez-faire one-sector real business cycle model under aggregate increasing returns, under sufficiently high degrees of productive externality, the demand-side effect in the labor market triggered by agents' expectations about the economy's future outweighs the supply-side effect, making agents' expectations become self-fulfilling. This paper analytically demonstrates that the conduct of monetary policy under nominal gross domestic product (GDP) targeting reinforces the supply-side effect in the labor market, thereby making belief-driven aggregate fluctuations more difficult to occur. This reinforcement effect on labor supply is absent under nominal consumption targeting and inflation targeting. Hence, under these two monetary regimes, the necessary and sufficient conditions for the economy to display equilibrium indeterminacy and sunspot fluctuations are identical to those in Benhabib and Farmer's laissez-faire economy. The results are robust to an endogenous growth extension of the model, implying that targeting the nominal GDP growth rate is more desirable than targeting the nominal consumption growth rate or the inflation rate in terms of macroeconomic stability.
The author would like to thank William A. Barnett (Editor) and two anonymous referees for very helpful comments and suggestions which substantially improved the paper.