Working Paper: CEPR ID: DP9820
Authors: Michael Hatcher; Patrick Minford
Abstract: We survey recent literature comparing inflation targeting (IT) and price-level targeting (PT) as macroeconomic stabilization policies. Our focus is on New Keynesian models and areas which have seen significant developments since Ambler?s (2009) survey: the zero lower bound on nominal interest rates; financial frictions; and optimal monetary policy. Ambler?s main conclusion that PT improves the inflation-output volatility trade-off in New Keynesian models is reasonably robust to these extensions, several of which are attempts to address issues raised by the recent financial crisis. The beneficial effects of PT therefore appear to hang on the joint assumption that agents are rational and the economy New Keynesian. Accordingly, we discuss recent experimental and survey evidence on whether expectations are rational, as well as the applied macro literature on the empirical performance of New Keynesian models. In addition, we discuss a more recent strand of applied literature that has formally tested New Keynesian models with rational expectations. Overall the evidence is not conclusive, but we note that New Keynesian models are able to match a number of dynamic features in the data and that behavioral models of the macroeconomy are outperformed by those with rational expectations in formal statistical tests. Accordingly, we argue that policymakers should continue to pay attention to PT.
Keywords: inflation targeting; price level targeting; rational expectations
JEL Codes: E31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| PT (Y20) | reduced volatility (G19) |
| model assumptions (C51) | empirical performance (L25) |
| model type (C52) | predictive accuracy (C52) |
| findings (Y40) | policy recommendations (D78) |