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Pareto Efficiency vs. the Ad Hoc Standard Monetary Objective An Analysis of Inflation Targeting

Listed author(s):
  • David Eagle

    (Eastern Washington University)

The standard ad hoc monetary objective function creates a bias in favor of inflation targeting. Instead, this paper uses the Pareto criterion to assess inflation targeting (IT), price-level targeting (PLT), and nominal-income targeting (NIT). The effect that unanticipated inflation or deflation benefits one party to a nominal contract while hurting the other party is an effect that cannot be captured in a model with a representative consumer or identical consumers. To capture this effect, this paper analyses models with diverse consumers in a pure-exchange economy without storage. When nominal aggregate demand (NAD) is stochastic but real aggregate supply (RAS) is not, PLT Pareto dominates IT. This is because IT perpetuates price errors and hence nominal aggregate demand errors, while PLT tries to return to the original targeted price path. By perpetuating these errors, IT perpetuates the welfare losses, whereas PLT corrects so to help reduce these welfare losses in the future. When RAS is also stochastic, nominal contracts under NIT can lead to Pareto efficiency when consumers have average relative risk aversion, non-stochastic endowment-to-RAS ratios, and no utility shocks. Under the same assumptions IT and PLT lead to Pareto inefficiencies because they force the payers of nominal contracts to guarantee the real value of those payments to the receivers. In essence this transfers RAS risk from the receivers of the nominal obligations to payers of the nominal obligations. However, this transfer of risk would only be appropriate if all payers of nominal obligations had below average relative risk aversion and all receivers had above average relative risk aversion, a situation that rarely will hold.

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Paper provided by EconWPA in its series Macroeconomics with number 0512020.

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Length: 22 pages
Date of creation: 29 Dec 2005
Handle: RePEc:wpa:wuwpma:0512020
Note: Type of Document - pdf; pages: 22. This uses Pareto efficiency to analyze inflation targeting, price-level targeting, and nominal- income targeting.
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  1. David Eagle, 2005. "Completing Markets in a One-Good, Pure Exchange Economy Without State-Contingent Securities," Finance 0501009, EconWPA.
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