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Price-level targeting and risk management in a low-inflation economy

  • Roberto M. Billi

With inflation and policy interest rates at historically low levels, policymakers show great concern about "downside tail risks" due to a zero lower bound on nominal interest rates. Low probability or tail events, such as sustained deflation or recession, are disruptive for the economy and can be difficult to resolve. This paper shows that price-level targeting mitigates downside tail risks respect to inflation targeting when policy is conducted through a simple interest-rate rule subject to a zero lower bound. Thus, price-level targeting is a more effective policy framework than inflation targeting for the management of downside tail risks in a low-inflation economy. At the same time, the average performance of the economy is not very different if policy implements price-level targeting instead of inflation targeting through a simple interest-rate rule. Price-level targeting may imply less variability of inflation than inflation targeting because policymakers can shape private-sector expectations about future inflation more effectively by targeting directly the price level path rather than inflation.

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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 08-09.

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Date of creation: 2008
Date of revision:
Handle: RePEc:fip:fedkrw:rwp08-09
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  1. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
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  7. Gaspar, Vítor & Smets, Frank & Vestin, David, 2007. "Is time ripe for price level path stability?," Working Paper Series 0818, European Central Bank.
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