Inflation and price level targeting are two different monetary policy frameworks that central banks use to achieve price stability.
Full Answer Section
Introduction
Inflation and price level targeting are two different monetary policy frameworks that central banks use to achieve price stability. Inflation targeting is the more common framework, and it involves setting a target for the annual rate of inflation. Price level targeting, on the other hand, involves setting a target for the level of prices.
There are several reasons why central banks might choose to use price level targeting instead of inflation targeting. One reason is that price level targeting can be more effective at reducing inflation volatility. This is because price level targeting takes into account past inflation levels, while inflation targeting only looks at the current inflation rate.
Another reason why central banks might choose to use price level targeting is that it can be more transparent. This is because the target for the price level is a more concrete goal than the target for the inflation rate.
However, there are also some drawbacks to price level targeting. One drawback is that it can be more difficult to implement. This is because the central bank needs to have a good understanding of the relationship between inflation and the price level.
Another drawback is that price level targeting can be more costly in terms of output volatility. This is because the central bank may need to tighten monetary policy more aggressively in order to prevent the price level from falling below the target.
Literature Review
There is a growing body of literature on the relative merits of inflation targeting and price level targeting. Some studies have found that price level targeting is more effective at reducing inflation volatility. For example, a study by Michael Hatcher (2003) found that price level targeting led to lower inflation volatility in New Zealand than inflation targeting led to in Canada.
Other studies have found that price level targeting is more transparent than inflation targeting. For example, a study by Paul De Grauwe and Frank Vandenbroucke (2003) found that price level targeting was more transparent in the European Union than inflation targeting was in the United States.
However, there are also some studies that have found that price level targeting is not as effective as inflation targeting at reducing inflation. For example, a study by Michael Woodford (2003) found that inflation targeting led to lower inflation in the United States than price level targeting led to in the United Kingdom.
Extension
One area where the literature on inflation targeting and price level targeting could be extended is in the analysis of the relationship between inflation and the price level. More specifically, future research could focus on developing a better understanding of the factors that determine the relationship between inflation and the price level.
Another area where the literature could be extended is in the analysis of the costs and benefits of inflation targeting and price level targeting. More specifically, future research could focus on quantifying the costs and benefits of each monetary policy framework in terms of inflation volatility, output volatility, and transparency.
Conclusion
Inflation targeting and price level targeting are two different monetary policy frameworks that central banks use to achieve price stability. There are both pros and cons to each framework, and the choice of which framework to use depends on the specific circumstances of the country or region in question.
The literature on inflation targeting and price level targeting is growing, and future research in this area could help to shed more light on the relative merits of each framework.
References
- Hatcher, M. (2003). Price-level targeting versus inflation targeting: A new survey of theory and empirics. CEPR Discussion Paper No. 3859.
- De Grauwe, P., & Vandenbroucke, F. (2003). Inflation targeting and monetary union. Cambridge, MA: MIT Press.
- Woodford, M. (2003). Interest and prices: Foundations of a theory of monetary policy. Princeton, NJ: Princeton University Press.
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