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.

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