Can Price-Level Targeting Reduce Exchange-Rate Volatility?

Abstract

Previous studies have shown that, under certain conditions, a central bank could achieve a better trade-off between inflation and output volatility by replacing its inflation target with a price-level target. This paper studies whether a Taylor rule that targets the price-level instead of the rate of inflation would be able to reduce nominal and real exchange rate volatility without compromising the goals of inflation and output stability. The results indicate that price-level targeting would be successful in reducing nominal and real exchange rate volatility in small open economies in the case of supply shocks, but in the case of demand shocks it would depend on those shocks’ persistence.