The Cost Channel, Indeterminacy, and Price-Level versus Inflation Stabilization

Sebastian Schmidt

The B.E. Journal of Macroeconomics, 2011, vol. 11, issue 1, 17

Abstract: In a New Keynesian model with a cost channel of monetary transmission, discretionary inflation targeting may become susceptible to a multiplicity of equilibria and results in a larger stabilization bias than in the standard model. Both observations can be attributed to a reduction in the effectiveness of the traditional demand channel of monetary transmission. Based on this insight, we evaluate the desirability of an alternative monetary policy regime, price-level targeting. We find that the latter is almost immune to equilibrium indeterminacy and remains successful in stabilizing output and inflation. Due to the weak demand channel, the ability of the central bank to manage private sector expectations takes center stage. This is accomplished by price-level targeting through the introduction of history dependence, but not by inflation targeting.

Keywords: price-level targeting; inflation targeting; New Keynesian model; cost channel; indeterminacy (search for similar items in EconPapers)
Date: 2011
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DOI: 10.2202/1935-1690.2226

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