Conventional wisdom suggests that the choice between price-level and inflation targeting involves a trade-off between low-frequency price-level uncertainty on the one hand, and high-frequency inflation and output uncertainty on the other. Price-level targeting thus offers the advantage of reduced long-term variability of the price level, but comes at the cost of increased short-term variability of inflation and output.

In Discussion Paper No. 1510, Lars Svensson reconsiders the relative merits of the two methods. He departs from previous analyses by applying a principal-agent approach in which society assigns an inflation or price level target to a central bank which can use its discretion in pursuing the target. Another departure from previous analyses is the presence of output and employment persistence. This is significant because, in the absence of persistence, there is only a trivial trade-off between long-term price variability and short-term inflation variability. Svensson thus shows that price-level targeting results in lower inflation variability than does inflation targeting. In addition, a price-level target has the advantage of eliminating any inflation bias that results under discretion if the employment target exceeds the natural rate of employment.

Price-Level Targeting versus Inflation Targeting: A Free Lunch?
Lars E O Svensson