Price level targeting under fiscal dominance

Abstract

The adoption of a “makeup” strategy has been one of the proposals in the review of the Fed’s monetary policy framework. Another suggestion, to avoid the zero lower bound, has been a more active role for fiscal policy. We put together these ideas to study price level targeting under a fiscally-led regime. We find that following a deflationary demand shock: (i) the central bank should increase (rather than decrease) the policy rate; (ii) the central bank, thus, avoids the zero lower bound; (iii) price level targeting is welfare improving with respect to inflation targeting, unless one considers a nonstandard inflation targeting rule with a negative inflation coefficient and a high degree of smoothing.