Price-level targeting and Inflation targeting – Part 1 The Theory

Ed Dolan of the EconoMonitor wrote a piece on the success/failure of the second round of quantitive easing in the USA. Basically QE2 failed in its function to increase GDP and reduce unemployment but has prevented a deflationary period in the US economy. However this depends if you look at data with a view to Price-Level targeting or Inflation targeting.

Price-level targeting and Inflation targeting
An inflation-targeting central bank tries to hold the price level on or close to a path that increases at a steady rate over time, say 2 percent per year. When everything is functioning smoothly, a price-level targeting central bank would aim for exactly the same path. The difference between the two policies comes when the inflation target is missed.

Suppose, as is the case in the United States now, inflation drops below its target rate for an extended period, as at point A in the chart below. (The vertical scale of the chart is exaggerated for clarity, but it is roughly based on actual U.S. data and Fed forecasts.) Having arrived at point A, the question is what kind of corrective action to take. The inflation targeter would take whatever actions are necessary to get the rate of inflation back to 2 percent. If successful, those actions would put the price level on a new path parallel to, but permanently below, the original one. The price-level targeter would instead undertake policies to return the price level to the original path, even though doing so would require the rate of inflation temporarily to exceed 2 percent, along the segment A to B, until the price level had made up for its earlier shortfall.

Both price-level targeting and inflation targeting are generally consistent with price stability which is the main goal of monetary policy. Either strategy can be interpreted as broadly in tune with price stability, but price stability is not the only goal of monetary policy amongst most central banks. In fact the US Fed operates under a dual directive of price stability and the achieving the highest level of employment. However price-level targeting is a more expansionary policy that is more likely to reduce unemployment but more importantly shouldn’t be responsible for an inflation level above what was intended from the outset. Part 2 will look at what has actually happened in the US economy after QE2.

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