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How Should Monetary Policy Be Conducted In An Era Of Price Stability?

  • Svensson, Lars E O

The paper discusses several issues related to how monetary policy should be conducted in an era of price stability. Low inflation (with base drift in the price level) and price-level stability (without such base drift) are compared, and a suitable loss function (corresponding to flexible inflation targeting) is discussed, including the index and level for the inflation target. Three ways of maintaining price stability are examined, namely (1) a commitment to a simple instrument rule, (2) "forecast targeting," and (3) monetary targeting. Both (1) and (3) are found to be inferior to forecast targeting. The benefits of credibility (private inflation expectations coinciding with the inflation target) are discussed. Credibility improves the tradeoff between inflation variability, output-gap variability and instrument variability and makes it easier for the central bank to meet is inflation target. The threat of deflation and a liquidity trap is examined. Transparent inflation targeting and a contingency plan with emergency measures, including a coordinated fiscal and monetary expansion, are likely to avoid a liquidity trap, but also contribute to escaping from one if already trapped.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2342.

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Date of creation: Dec 1999
Date of revision:
Handle: RePEc:cpr:ceprdp:2342
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  1. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  2. Woodford, Michael, 2000. "Optimal Monetary Policy Inertia," Seminar Papers 666, Stockholm University, Institute for International Economic Studies.
  3. Meltzer, Allan H, 1987. "Limits of Short-run Stabilization Policy: Presidential Address to the Western Economic Association, July 3, 1986," Economic Inquiry, Western Economic Association International, vol. 25(1), pages 1-14, January.
  4. Willem H. Buiter & Nikolaos Panigirtzoglou, 1999. "Liquidity Traps: How to Avoid Them and How to Escape Them," NBER Working Papers 7245, National Bureau of Economic Research, Inc.
  5. Ben S. Bernanke & Ilian Mihov, 1996. "What Does the Bundesbank Target?," NBER Working Papers 5764, National Bureau of Economic Research, Inc.
  6. George A. Akerlof & William R. Dickens & George L. Perry, 1996. "The Macroeconomics of Low Inflation," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(1), pages 1-76.
  7. Laubach, T. & Posen, A.S., 1997. "Disciplined Discretion: Monetary Targeting in Germany and Switzerland," Princeton Essays in International Economics 206, International Economics Section, Departement of Economics Princeton University,.
  8. Kareken, John H & Muench, Thomas & Wallace, Neil, 1973. "Optimal Open Market Strategy: The Use of Information Variables," American Economic Review, American Economic Association, vol. 63(1), pages 156-72, March.
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