Can Price-Level Targeting Reduce Exchange Rate Volatility?

Abstract

Previous studies have shown that, under certain conditions, a central bank can achieve a better trade-off between inflation and output volatility by replacing its inflation target with a price-level target. This article studies whether a Taylor rule that targets the price level instead of the inflation rate can reduce nominal and real exchange rate volatility without compromising the goals of inflation and output stability. The results indicate that supply shocks cause less nominal and real exchange rate volatility under price-level targeting. However, in the case of demand shocks the results depend on the persistence of the shocks.