Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Panel estimates based on 19 transition economies suggests that some central banks may aim at comparatively high inflation rates mainly to make up for, and to perhaps exploit, lagging internal and external liberalization in their economies. Out-of-sample forecasts, based on expected developments in the underlying structure of these economies, and assuming no changes in institutions, suggest that incentives may be diminishing, but not to the point where inflation levels below 5 percent could credibly be announced as targets. Greater economic liberalization would help reduce incentives for higher inflation, and enhancements to central bank independence could help shield these central banks from pressures. Terms of use: Documents in

Abstract:Recent research has shown that optimal monetary policy may display considerable price-level drift. Proponents of price-level targeting have argued that the costs of eliminating the price-level drift may be reduced if the central bank responds flexibly by returning the price level only gradually to the target path (Gaspar et al., 2010). We revisit this argument in two variants of the New Keynesian model. We show that in a two-sector version of the model which allows for changes in relative prices across sectors, the costs of stabilisation under price-level targeting remain much higher than under inflation targeting for all policy-relevant horizons. Our conclusion is that extending the policy horizon is not a panacea to reduce the costs of eliminating pricelevel drift.Keywords: price-level targeting, optimal monetary policy, commitment JEL-Classification: E58, E42, E31 Non technical summaryIn the canonical New Keynesian model, the optimal monetary policy response to shocks implies a stationary price level. This remarkable result has been put forward as an argument in favour of price-level targeting. However, the optimality of a stationary price level is a very special result, and recent research has shown that optimal monetary policy may display price-level drift if the canonical model is only slightly modified.If optimal monetary policy involves a non-stationary price level, reverting the price level to the target path will inevitably stabilise prices too much and, consequently, lead to higher volatility of other variables. Yet, to our knowledge, the potential costs of eliminating price-level drift have not been analysed systematically so far. Instead, proponents of price-level targeting have argued that the costs of eliminating the pricelevel drift may decline if the central bank responds flexibly by returning the price level only gradually to its steady state. In this paper we show one example in which the argument is correct and one example in which it is not.In our first example, a New Keynesian model with price-level drift, we find that (i) bringing back the price level to its target at a very short policy horizon leads to high volatility and welfare costs, (ii) inflation targeting is better than price-level targeting for policy horizons longer than two quarters, but (iii) for a policy horizon of two years or longer the costs of stabilisation under price-level targeting are not notably higher than those under inflation targeting.In our second example, a two-sector extension of the New Keynesian model, we illustrate that the costs of stabilisation under price-level targeting remain high over a policy-relevant horizon. Specifically, we find that (i) targeting the price level or the inflation rate at short policy horizons leads to high volatility in other welfare-relevant variables and thus to high welfare losses, (ii) inflation targeting is better than price-level targeting for policy horizons longer than two quarters, and (iii) in contrast to inflation targeting the costs of stabilisation under price...

The last review of the ECB's monetary policy strategy in 2003 followed a period of predominantly upside risks to price stability. Experience following the 2008 financial crisis has focused renewed attention on the question of how monetary and fiscal policy should best interact, in particular in an environment of structurally low interest rates and persistent downside risks to price stability. This debate has been further intensified by the economic impact of the coronavirus (COVID-19) pandemic. In the euro area, the unique architecture of a monetary union consisting of sovereign Member States, with cross-country heterogeneities and weaknesses in its overall construction, poses important challenges.12 Tax policy may also substitute interest rate policy to change real interest rates (the cost of current consumption in terms of future consumption), even in the case of balanced budgets. See Feldstein (2002) and Correia et al. (2013).