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Price Level Targeting in a Small Open Economy with Financial Frictions: Welfare Analysis

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Author Info

  • Ali Dib
  • Caterina Mendicino
  • Yahong Zhang

Abstract

How important are the benefits of low price-level uncertainty? This paper explores the desirability of price-level path targeting in an estimated DSGE model fit to Canadian data. The policy implications are based on social welfare evaluations. Compared to the historical inflation targeting rule, an optimal price level targeting regime substantially reduces the welfare cost of business cycle fluctuations in terms of steady state consumption. The optimal price-level targeting rule performs also better than the optimal inflation targeting rule in minimizing the distortion generated by the presence of nominal debt contracts. The occurrence of financial shocks, which are among the main sources of business cycle fluctuations in the model, significantly contributes to quantify the welfare gains of price level targeting.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 08-40.

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Length: 53 pages
Date of creation: 2008
Date of revision:
Handle: RePEc:bca:bocawp:08-40

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Related research

Keywords: Financial stability; Inflation and prices; Monetary policy framework;

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Cited by:
  1. PIROVANO, Mara, 2013. "International financial integration, credit frictions and exchange rate regimes," Working Papers 2013015, University of Antwerp, Faculty of Applied Economics.
  2. Mark J. Carney, 2009. "Commentary: using monetary policy to stabilize economic activity," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 297-311.
  3. Carl E. Walsh, 2009. "Using monetary policy to stabilize economic activity," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 245-296.
  4. Gerke, R. & Jonsson, M. & Kliem, M. & Kolasa, M. & Lafourcade, P. & Locarno, A. & Makarski, K. & McAdam, P., 2013. "Assessing macro-financial linkages: A model comparison exercise," Economic Modelling, Elsevier, vol. 31(C), pages 253-264.
  5. Shin-Ichi Nishiyama, 2011. "How Important are Financial Shocks for the Canadian Business Cycle?," TERG Discussion Papers 276, Graduate School of Economics and Management, Tohoku University.
  6. Francisco Covas & Yahong Zhang, 2010. "Price-level versus inflation targeting with financial market imperfections," Canadian Journal of Economics, Canadian Economics Association, vol. 43(4), pages 1302-1332, November.
  7. Hatcher, Michael C., 2011. "Comparing inflation and price-level targeting: A comprehensive review of the literature," Cardiff Economics Working Papers E2011/22, Cardiff University, Cardiff Business School, Economics Section.
  8. Yahong Zhang, 2013. "Unemployment Fluctuations in a Small Open-Economy Model with Segmented Labour Markets: The Case of Canada," Working Papers 13-40, Bank of Canada.
  9. Merola, Rossana, 2010. "Optimal monetary policy in a small open economy with financial frictions," Discussion Paper Series 1: Economic Studies 2010,01, Deutsche Bundesbank, Research Centre.
  10. Jeannine Bailliu & C├ęsaire Meh & Yahong Zhang, 2012. "Macroprudential Rules and Monetary Policy when Financial Frictions Matter," Working Papers 12-6, Bank of Canada.
  11. Hatcher, Michael C. & Minford, Patrick, 2013. "Stabilization policy, rational expectations and price-level versus inflation targeting: a survey," Cardiff Economics Working Papers E2013/14, Cardiff University, Cardiff Business School, Economics Section.
  12. Yahong Zhang, 2011. "Financial Frictions, Financial Shocks and Labour Market Fluctuations in Canada," Discussion Papers 11-10, Bank of Canada.

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