Optimal monetary policy: is price‐level targeting the next step? (original) (raw)
Related papers
Price and Output Stability Under Price Level Targeting
Social Science Research Network, 2001
It is commonly believed that a monetary policy that targets the price level reduces the long-term variability of the price level but only at the cost of increased variability in both inflation and output. This paper shows that this result may not hold so long as increases in the real rate of interest cause decreases in aggregate demand. In particular it is shown that the one-step-ahead variance of output and inflation are lower under price-level targeting than under inflation targeting. Further, it is shown that the variance of inflation about its target value can be lower under price-level targeting than under inflation targeting. This increased stability under price level targeting works through an interest rate channel not previously identified in the literature on price-level and inflation targeting.
Price Adjustment: Inflation Targeting or Price-Level Targeting?∗
2006
I investigate optimal monetary policy in the sticky information model of price ad-justment within a New Keynesian macroeconomic framework. The model is solved for optimal policy, and welfare implications of three alternative monetary policy regimes: unconstrained policy, price-level targeting and inflation targeting, are compared when there is a shock to the economy. The results for a cost-push shock illustrate that optimal policy depends on the degree of price stickiness and the persistence of the shock. Infla-tion targeting is the optimal policy if prices are flexible enough or the shock is persistent enough. However, for a demand shock, inflation targeting emerges as the best policy for all values of the price stickiness and the shock’s persistence. When the volatility of nomi-nal interest rate is taken into consideration, the results indicate that inflation targeting is the best policy, in the sense that it results in smaller welfare loss and volatility of nominal interest rate,...
Price Level Targeting vs. Inflation Targeting: A Free Lunch?
1996
Price level targeting (without base drift) and inflation targeting (with base drift) are compared under commitment and discretion, with persistence in unemployment. Price level targeting is often said to imply more short-run inflation variability and thereby more employment variability than inflation targeting. Counter to this conventional wisdom, under discretion a price level target results in lower inflation variability than an inflation target (if unemployment is at least moderately persistent). A price level target also eliminates the inflation bias under discretion and, as is well known, reduces long-term price variability. Society may be better off assigning a price level target to the central bank even if its preferences correspond to inflation targeting. A price level target thus appears to have more advantages than commonly acknowledged.
Endogenous Rule-of-Thumb Price Setters and Monetary Policy
Studies evaluating the e¢ cacy of monetary policy rules and regimes are often based a benchmark new Keynesian model where the parameters are assumed to be policy invariant. It is possible, however, that some key parameters may not be invariant to changes in monetary policy. In this paper, we use a hybrid new Keynesian Phillips curve to examine the in‡ation versus price-level targeting debate when the proportion of rule-of- thumb price setters is allowed to change endogenously with the monetary regime. Although there are other factors that may also be endogenous, we focus on in‡ation inertia since it has been identi…ed in the literature as a crucial parameter aecting the performance of monetary policy. � This paper was prepared for the Bank of Canada's annual conference entitled "New Frontiers in Monetary Policy Design," to be held November 12 and 13, 2009. The views expressed are the authors'and do not necessarily re‡ect those of the Bank of Canada or its sta¤.
Price-Level Targeting and Stabilization Policy: A Review
2007
The author surveys recent articles on the costs and benefits of price-level targeting versus inflation targeting, focusing on the benefits and costs of price-level targeting as a tool for stabilization policy. He reviews papers that examine how price-level targeting affects the short-run trade-off between output and inflation variability by influencing expectations of future inflation. The author looks at the implications of this argument for assigning an objective based on price-level targeting to a central bank that is unable to commit to its future policies. He discusses some recent papers that examine how price-level targeting can help to avoid the zero-bound problem, and papers that examine the incentives created by price-level targeting to change the degree of indexation of private contracts.
2011
Economic researchers have not yet quantified the long-term benefits of price-level targeting. Consequently, central banks are unable to conduct a full cost-benefit analysis vis-a-vis inflation targeting. The primary contribution of this thesis is to quantify these benefits within a dynamic stochastic general equilibrium framework, thereby laying the foundations for a full cost-benefit analysis. The thesis focuses on three key areas: consumption volatility social welfare and inflation risk premia on long-term nominal contracts. Conventional wisdom holds that the main benefit of price-level targeting is a reduction in long-term inflation risk. However, the current workhorse model for monetary analysis cannot be used to evaluate this benefit, because long-term inflation risk does not affect agents' welfare. This thesis therefore builds and simulates overlapping generations models in which long-term inflation risk matters for social welfare. In these models, consumers save over a lo...
Stabilisation Policy, Rational Expectations and Price-Level Versus Inflation Targeting: A Survey
Journal of Economic Surveys, 2014
We survey literature comparing in ‡ation targeting (IT) and price-level targeting (PT) as macroeconomic stabilisation policies. Our focus is on New Keynesian models and areas that have seen signi…cant developments since Ambler's (2009) survey: optimal monetary policy; the zero lower bound; …nancial frictions; and transition costs of adopting a PT regime. Ambler's conclusion that PT improves social welfare in New Keynesian models is fairly robust, but we note an interesting split in the literature: PT consistently outperforms IT in models where policymakers commit to simple Taylor-type rules, but results in favour of PT when policymakers minimise loss functions are overturned with small deviations from the baseline model. Since the bene…cial e¤ects of PT appear to hang on the joint assumption that agents are rational and the economy New Keynesian, we discuss survey and experimental evidence on rational expectations and the applied macro literature on the empirical performance of New Keynesian models. Overall, the evidence is not clear-cut, but we note that New Keynesian models can pass formal statistical tests against macro data and that models with rational expectations outperform those with behavioural expectations (i.e. heuristics) in direct statistical tests. We therefore argue that policymakers should continue to pay attention to PT.
Price Level Targeting and Risk Management
SSRN Electronic Journal, 2015
Many argue that, because the outlook for the economy is uncertain, monetary policy should apply a risk management approach by raising the policy interest rate gradually from its lower bound. Using a small New Keynesian model, I study the impact of outlook uncertainty on the economic performance of a central bank with a target for the price level or the level of nominal gross domestic product. I show that, in the presence of persistent supply and demand shocks, a price-level target is more e¤ective at mitigating outlook uncertainty because it induces greater policy inertia and improves the tradeo¤s faced by the central bank.
Price-Level Targeting and Risk Management in a Low-Inflation Economy
SSRN Electronic Journal, 2008
With inflation and policy interest rates at historically low levels, policymakers show great concern about "downside tail risks" due to a zero lower bound on nominal interest rates. Low probability or tail events, such as sustained deflation or recession, are disruptive for the economy and can be difficult to resolve. This paper shows that price-level targeting mitigates downside tail risks respect to inflation targeting when policy is conducted through a simple interest-rate rule subject to a zero lower bound. Thus, price-level targeting is a more effective policy framework than inflation targeting for the management of downside tail risks in a low-inflation economy. At the same time, the average performance of the economy is not very different if policy implements price-level targeting instead of inflation targeting through a simple interest-rate rule. Price-level targeting may imply less variability of inflation than inflation targeting because policymakers can shape private-sector expectations about future inflation more effectively by targeting directly the price level path rather than inflation.