Limited commitment, endogenous credibility and the challenges of price‐level targeting

Abstract

AbstractThis paper studies the cost of limited commitment when a central bank commits to a price‐level target path but retains the discretion to re‐optimize it whenever the cost of honouring its commitment exceeds a tolerance threshold. Such discretion undermines the credibility of the price‐level target path and weakens its effectiveness to stabilize the economy. Endogenous target resets are more costly than exogenous target re‐optimizations and can give rise to multiple equilibria, including a low credibility equilibrium with frequent target resets and high volatility. Canadian data suggest that price‐level target resets could be quite frequent in practice.