Stabilisation Policy, Rational Expectations and Price‐level Versus Inflation Targeting: A Survey

Abstract

We survey literature comparing inflation targeting (IT) and price‐level targeting (PT) as macroeconomic stabilisation policies. Our focus is on New Keynesian models and areas that have seen significant developments since Ambler's (2009, Price‐level targeting and stabilisation policy: a survey. Journal of Economic Surveys 23(5): 974–997) survey: optimal monetary policy; the zero lower bound; financial frictions and transition costs of adopting a PT regime. Ambler's conclusion that PT improves social welfare in New Keynesian models is fairly robust, but we note an interesting split in the literature: PT consistently outperforms IT in models where policymakers commit to simple Taylor‐type rules, but results in favour of PT when policymakers minimise loss functions are overturned with small deviations from the baseline model. Since the beneficial effects of PT appear to hang on the joint assumption that agents are rational and the economy New Keynesian, we discuss survey and experimental evidence on rational expectations and the applied macro literature on the empirical performance of New Keynesian models. Overall, the evidence is not clear‐cut, but we note that New Keynesian models can pass formal statistical tests against macro data and that models with rational expectations outperform those with behavioural expectations (i.e. heuristics) in direct statistical tests. We therefore argue that policymakers should continue to pay attention to PT.

On Model-Consistent Expectations in Macroeconomics

“…Alternative tests were proposed by Hoffman and Schmidt (1981) and Veall (1985a,1985b). Hatcher and Minford (2016) present an alternative strategy for testing M-Ca: the "indirect inference procedures". The suggestion there is to compare the VAR parameters drawn from the data and the mean VAR coefficients estimated from bootstrapped samples from the full macro model, after imposing the restrictions on parameters implied by the theory.…”

“…In this regard, it is known that non-linear restrictions on structural parameters may imply complicated (or non-convergent) iteration processes; thus the convenience of using the unrestricted model, as allowed by the approach we follow here. For a broader discussion, see, for example, Hatcher and Minford (2016), Le et al (2011), Liu and Minford (2014).…”

An International Perspective on the Recent Behavior of Inflation

“…Hammond (2012) provides an excellent review of the main modalities and country experiences. Hatcher and Minford (2013) survey recent strands of the literature to compare inflation targeting and price-level targeting as macroeconomic stabilization policies. As Hammond (2012, p. 5) explains, (i) Price stability is explicitly recognised as the main goal of monetary policy.…”

Wicksellian Rules and the Taylor Principle: Some Practical Implications*

“…Despite the renewed interest in PLT (e.g., Vestin, 2006;Gaspar et al, 2010;Billi, 2008;Ambler, 2009;Hatcher and Minford, 2016), there have only been a few studies investigating the properties of Wickesllian rules in the context of New Keynesian models, in terms of their ability to stabilize the economy. Some notable examples are Kerr and King (1996) and Woodford (2003), who conclude, in different set-ups, that if the monetary authority adjusts the interest rate in response to deviations of the price level from a target path, then there is a unique equilibrium under a wide range of parameter choices; all that is required is that the monetary authority raises the nominal rate when the price level is above the target path, and lowers it when the price level is below the target path.…”