Working Paper: CEPR ID: DP12739
Authors: Seppo Honkapohja; Kaushik Mitra
Abstract: We examine global dynamics under learning in a nonlinear New Keynesian model when monetary policy uses price-level targeting and compare it to inflation targeting. Domain of attraction of the targeted steady state gives a robustness criterion for policy regimes. Robustness of price-level targeting depends on whether a known target path is incorporated into learning. Credibility is measured by accuracy of this forecasting method relative to simple statistical forecasts. Credibility evolves through reinforcement learning. Initial credibility and initial level of target price are key factors influencing performance. Results match the Swedish experience of price level stabilization in 1920's and 30's.
Keywords: adaptive learning; limited credibility; inflation targeting; zero interest rate lower bound
JEL Codes: E63; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Price Level Targeting (PLT) (E31) | Escape from recession (E32) |
| Credibility (D83) | Effectiveness of Price Level Targeting (PLT) (E31) |
| Initial credibility (Y20) | Domain of attraction for targeted steady state (C62) |
| Initial price level targeted (E30) | Domain of attraction for targeted steady state (C62) |
| Price Level Targeting (PLT) under full credibility (E31) | Outperformance of Inflation Targeting (IT) (E61) |
| Small degree of initial credibility (D83) | Enhancement of domain of attraction (C62) |
| Price Level Targeting (PLT) (E31) | Convergence back to target steady state (C62) |
| Liquidity trap scenarios (E41) | Superiority of Price Level Targeting (PLT) over Inflation Targeting (IT) (E31) |