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Aggregate and welfare effects of long run inflation risk under inflation and price-level targeting

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  • Michael, Hatcher

Abstract

This paper presents a DSGE model in which long run inflation risk matters for social welfare. Aggregate and welfare effects of long run inflation risk are assessed under two monetary regimes: inflation targeting (IT) and price-level targeting (PT). These effects differ because IT implies base-level drift in the price level, while PT makes the price level stationary around a target price path. Under IT, the welfare cost of long run inflation risk is equal to 0.35 percent of aggregate consumption. Under PT, where long run inflation risk is largely eliminated, it is lowered to only 0.01 per cent. There are welfare gains from PT because it raises average consumption for the young and lowers consumption risk substantially for the old. These results are strongly robust to changes in the PT target horizon and fairly robust to imperfect credibility, fiscal policy, and model calibration. While the distributional effects of an unexpected transition to PT are sizeable, they are short-lived and not welfare-reducing.

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File URL: http://repo.sire.ac.uk/handle/10943/450
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Paper provided by Scottish Institute for Research in Economics (SIRE) in its series SIRE Discussion Papers with number 2013-19.

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Date of creation: 2013
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Handle: RePEc:edn:sirdps:450

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Keywords: inflation targeting; price-level targeting; inflation risk; monetary policy;

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  1. Links for 02-13-2013
    by Mark Thoma in Economist's View on 2013-02-13 00:03:00

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