Price-level Targeting Research Articles

Monetary Policy and Built–In Stability

Concern about globalization has rekindled interest in a longstanding issue—the implications for macroeconomic stability of alternative monetary/exchange–rate policies. This paper re–examines the issue, and it assesses the robustness of several recommendations by comparing the results of a series of small open–economy macro models. All involve model–consistent exchange–rate expectations and (through the existence of intermediate imports) supply–side effects of exchange–rate changes. The first model is descriptive, while the second and third allow for more thorough–going micro foundations and forward–looking behavior—first on the supply side (with multiperiod overlapping contracts), and then on the demand side (with the Ramsey theory of consumption). To clarify the impact of each change in model specification, they are introduced one at a time, and the same questions are posed at each stage. Two issues are examined—the implications of alternative monetary policies for (i) the effect on output of a one–time (unexpected) change in demand, and (ii) the effect on the amplitude of the business cycle that accompanies an ongoing (anticipated) cycle in demand. Three policies are compared: price–level targeting, wage–rate targeting, and exchange–rate targeting.

Exploring the Role of the Real Exchange Rate in Australian Monetary Policy

An important issue in small open-economies is whether policymakers should respond to exchange rate movements when they formulate monetary policy. Micro-founded models tend to suggest that there is little to be gained from responding to exchange rate movements, and the literature has largely concluded that such a response is unnecessary, or even undesirable (Taylor, 2001). This paper examines this issue using an estimated model of the Australian economy. In contrast to micro-founded models, according to this model policymakers should allow for movements in the real exchange rage and the terms-of-trade when they set interest rates. Further, taking real exchange rate movements into account appears even more important with price level targeting than with inflation targeting.

Inflation and Price Level Targeting in a New Keynesian Model

In a New Keynesian macroeconomic model under credible commitment, price level targeting dominates inflation targeting. But with sufficient inflation aversion the inflation–targeting central bank can produce quantitatively similar results to one targeting the price level. The current degree of inflation aversion demonstrated by the Bank of England may be sufficient to reap the benefits of price level targeting.

Cible de niveau de prix versus cible d'inflation : état des lieux et perspectives

Price level versus inflation targeting : achievement and challenges Should a central Bank target the inflation or rather the price level to maximise the social welfare ? This article analyses this question which is essentially set in a new keynesian framework, characterised by nominal rigidities and rational anticipations. First, this article exposes inherent mechanisms to the two types of target. Then it gives an outline of the stakes on which the studies on this subject mainly focused. The authors introduce then the notion of credibility of the monetary policy into a new keynesian environment, a good understanding of which is necessary for the intuition of the results on the choice of the target. Finally, the discussion is widened by introducing various additional aspects susceptible to be more effectively resolved under a price level targeting. JEL classifications : E5, E52.

The Credibility of the Monetary Policy 'Free Lunch'

Price level targeting has been proposed as an alternative to inflation targeting that may confer benefits if a central bank sets policy under discretion, even if society's loss function is specified in terms of inflation (instead of price level) volatility. This paper demonstrates the sensitivity of this argument. If even a small portion of agents believes that inflation will continue in the future at current levels, or does not fully understand the nature of the target, price level targeting may in fact impose costs on society rather than benefits, especially if inflation volatility has a high weight in society's loss function. While rational expectations and perfect credibility are generally beneficial with either a price level or an inflation target, an inflation target is more robust to alternative assumptions. These results suggest that caution should be exercised in considering a price level target as the basis for monetary policy, unless society has preferences specified in terms of price level, rather than inflation, volatility.

Exploring the Role of the Real Exchange Rate in Australian Monetary Policy

An important issue in small open-economies is whether policymakers should respond to exchange rate movements when they formulate monetary policy. Micro-founded models tend to suggest that there is little to be gained from responding to exchange rate movements, and the literature has largely concluded that such a response is unnecessary, or even undesirable. This paper examines this issue using an estimated model of the Australian economy. In contrast to microfounded models, according to this model policymakers should allow for movements in the real exchange rate and the terms-of-trade when they set interest rates. Further, taking real exchange rate movements into account appears even more important with price level targeting than with inflation targeting.

Monetary Indicators and Policy Rules in the P-Star Model

There is a broad consensus among economists that, in the long run, inflation is a monetary phenomenon. However, monetary policy is often analysed using models that have no causal role for monetary aggregates in the propagation of inflationary processes. Moreover, impulses from monetary policy actions are transmitted to inflation through the output gap alone. This paper analyses monetary indicators and monetary policy rules within the framework of a small monetary model, the P-star model. In this model monetary aggregates play an active role in the transmission mechanism of monetary policy actions. Interest rate impulses affect inflation through two channels, the output gap and the liquidity gap. Section 2 of the paper analyses monetary indicators of inflation. Using a long-run money demand function, three monetary indicators are discussed: the monetary overhang, the price gap, and the nominal money gap. The price gap is a comprehensive indicator of inflationary pressure, combining information from the aggregate goods market (output gap) and the money market (liquidity gap). Some implications of using the price gap in Phillipstype equations for the dynamics of inflation are discussed as well. Section 3 analyses the role of the price gap in the monetary transmission process more closely. The P-Star model and a New-Keynesian-Taylor-type model are compared with respect to their stability properties, implied sacrifice ratios and the efficiency of interest rate policy in stabilising inflation and output fluctuations. Section 4 explores a range of monetary policy rules within the P-star model. First, direct inflation targeting, inflation forecast targeting, and optimal inflation targeting are analysed and contrasted with a strategy of price-level targeting, often suggested as an alternative to inflation-based rules. Second, assuming a more general loss function for the central bank, a Taylor rule (focussing on inflation and output), monetary targeting and a two-pillar strategy (focussing on monetary growth and inflation) are analysed. The performance of these rules is investigated under perfect foresight and rational expectations of the central bank. Moreover, these strategies are compared to two benchmarks, a passive rule and a broadly based meta-strategy. Finally, monetary targeting as an intermediate targeting strategy is compared to a Taylor rule when the central bank has an information advantage with respect to monetary growth.

Price and Output Stability Under Price Level Targeting

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.

Interest Rate Feedback Rules in an Open Economy with Forward Looking Inflation

With the adoption of an explicit inflation target in the UK, there has been renewed interest in the properties of alternative interest rate feedback rules. Following Svensson (1999) a literature examining the relative merits of inflation and price level targeting has also developed. In this paper we compare the stabilization properties of the two forms of feedback rule that have been used most frequently in the literature and which give rise to price level and inflation targeting, respectively. The model in which we embed our rules is significantly richer than those considered in the price level targeting literature and this allows us to explain why the relative performance of the rules is dependent upon the nature of the shock considered and whether or not excess inflation is defined in terms of consumer or output price inflation.

Comment on Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates

The sharp decline in interest rates in the past two decades has shifted attention to a new policy question. Do low interest rates interfere with the ability of a central bank to do its job? Some say the answer is yes. According to them, with rates low the central bank has lost the option to cut them further in the event of a bad economic shock. 1 According to McCallum, the right answer is no. He asserts that the central bank has a second tool for stabilizing the economy: the exchange rate. He maintains that the central bank can stabilize the economy by exploiting its control over the exchange rate, even if it cannot cut the interest rate because it is stuck on its zero lower bound. According to McCallum's model, exchange rate policy can even lift the economy out of the worst case scenario. This occurs when the nominal rate of interest is zero and the expected future price level and exchange rate are Sxed because the public Srmly believes the central bank is committed to a price level target. In this scenario, a standard prescription for stimulating the economy reduce the real interest 1ate by committing to loose money in the future is ineffective. According to McCallum's model, this worst case scenario is not as big a problem as it might seem. The central bank can still stimulate the economy by depreciating the currency through purchases of foreign exchange. In my comment I make two points:

Price Level Stability: Some Issues

This article challenges the conventional wisdom that price level targeting necessarily increases the volatility of inflation and economic activity. It shows that the optimal policy under commitment for a society that cares only about the variability of output and inflation involves only a limited degree of base drift. The result crucially depends on the importance of forward-looking behaviour and on the credibility of the commitments. The case for price level targeting is strengthened when the possibility of a binding lower bound on nominal interest rates is considered. This may be increasingly relevant in a low inflation environment. This justifies renewed interest on price level targets in the context of thinking through how to prevent and respond to deflationary risks.

Price-level targeting -the next objective for monetary policy?

Inflation-targeting monetary policy is compared with price-level targeting. It is argued that price-level targeting offers greater certainty about the long-term inflation rate, greater economic growth, a superior response to a deflationary depression, and other advantages.

Using Futures Prices to Control Inflation: Reply to Garrison and White

In a recent paper, Garrison and White (G-W, 1997) offered a thoughtful and skeptical assessment of several recent proposals to use price-index futures contracts to achieve price-level targets. Their main focus is a scheme put forward by Sumner (1995), but they also addressed a scheme that I suggested (Dowd 1994, 1995) and made substantial criticisms of price-index futures schemes in general. Sumner (1997) has already replied to those that pertain to his scheme, and this reply responds to those that pertain to mine.1 The objective of my scheme is to achieve price stability whilst also making the monetary system fully automatic (and so doing away with discretionary monetary policy). This objective would be achieved by the central bank pegging the price of price-index futures contracts, and then relying on private-sector arbitrage to ensure that the money supply is consistent with a stable expected price level. The actual price level would then be equal to this expected price level plus or minus a (hopefully, small) random error.

What Do New-Keynesian Phillips Curves Imply for Price-Level Targeting?

What Do New-Keynesian Phillips Curves Imply for Price-Level Targeting?

Price-Level Targeting versus Inflation Targeting: A Free Lunch?

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.

Pioneering price level targeting: The Swedish experience 1931–1937

In September 1931, Sweden became the first country to make the stabilization of the domestic price level the official goal of its monetary policy, actually the only country that so far has adopted such an explicit price level target. Starting from the issues and concepts familiar from research and policy experience of inflation targeting – as contrasted to price level targeting – this paper examines the evolution of the Swedish price level targeting in the 1930s. We bring out a number of similarities and differences between price stabilization in the 1930s and in the 1990s.

The Inflation-Output Variability Tradeoff and Price-Level Targets

The authors describe a popular monetary policy framework based on a neoclassical Phillips curve model. Here, the choice between an inflation target and a price-level target depends on characteristics of real output. If the output gap is relatively persistent, then targeting the price level results in a better set of policy options for the central bank.

Monetary Policy under Neoclassical and New-Keynesian Phillips Curves, with an Application to Price Level and Inflation Targeting

This paper compares discretionary monetary policy under two Phillips curves. Previous work uses a Phillips curve consistent with \Neoclassical models of price adjustment. Sticky price models imply a \New-Keynesian Phillips curve based on staggered price setting that delivers familiar results on an inflationary bias and inflation contracts. However, the comparison of price level and inflation targeting reveals an output/price stability tradeoff under the New-Keynesian model that does not arise under the Neoclassical specification, illustrating the usefulness of considering the New-Keynesian model. Given the empirical support for the New-Keynesian specification, a stability tradeoff likely exists.

Alternative Nominal Anchors

In this paper, the choice of an intermediate target for monetary policy is considered using a model that allows each alternative to be judged based on its welfare effects, measured using a representative household's utility function. The results show that nominal income targeting is preferable to money supply targeting since it provides an appropriate response to money demand shocks. Price-level targeting dominates nominal income targeting, however, since it also provides an appropriate response to technology shocks. In fact, these results imply that price-level targeting represents the optimal monetary policy.

Considerations in Reducing Inflation From Low to Lower Levels

In recent years, many countries have successfully reduced their inflation rates to relatively low levels of 2 to 3 percent. The question then arises as to whether it would be desirable to move to even lower rates of inflation. The paper examines the benefits and costs of moving from low inflation to even lower inflation by drawing together recent work on this issue. Once a country has decided to move to an even lower rate of inflation, the question then becomes whether it would be better to achieve this objective through inflation targeting or price-level targeting. The paper critically reviews the arguments for both approaches.