DP12739 Price Level Targeting with Evolving Credibility

Author(s): Seppo Honkapohja, Kaushik Mitra
Publication Date: February 2018
Keyword(s): Adaptive Learning, Inflation targeting, Limited Credibility, Zero Interest Rate Lower Bound
JEL(s): E52, E58, E63
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12739

We examine global dynamics under learning in a nonlinear New Keynesian model when monetary policy uses price-level targeting and compare it to inflation targeting. Domain of attraction of the targeted steady state gives a robustness criterion for policy regimes. Robustness of price-level targeting depends on whether a known target path is incorporated into learning. Credibility is measured by accuracy of this forecasting method relative to simple statistical forecasts. Credibility evolves through reinforcement learning. Initial credibility and initial level of target price are key factors influencing performance. Results match the Swedish experience of price level stabilization in 1920's and 30's.