Price-level targeting versus inflation targeting over the long-term

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Hatcher, Michael ; Cardiff University (2011)
  • Publisher: Cardiff University
  • Subject: HB

This paper investigates the long-term impact of price-level targeting on social welfare in an overlapping generations model in which the young save for old age by investing in productive capital and indexed and nominal government bonds. A key feature of the model is that the extent of bond indexation is determined endogenously in response to monetary policy as part of an optimal commitment Ramsey policy. Due to the absence of base-level drift under price-level targeting, long-term inflation risk is reduced by an order of magnitude compared to inflation targeting. Consequently, real bond returns are stabilised somewhat, and consumption volatility for old generations is reduced by around 15 per cent. The baseline welfare gain from pricelevel targeting is equivalent to a permanent increase in aggregate consumption of only 0.01 per cent, but this estimate is strongly sensitive on the upside.
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