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Pareto Efficiency vs. the Ad Hoc Standard Monetary Objective An Analysis of Inflation Targeting

David Eagle ()

Macroeconomics from University Library of Munich, Germany

Abstract: The standard ad hoc monetary objective function creates a bias in favor of inflation targeting. Instead, this paper uses the Pareto criterion to assess inflation targeting (IT), price-level targeting (PLT), and nominal-income targeting (NIT). The effect that unanticipated inflation or deflation benefits one party to a nominal contract while hurting the other party is an effect that cannot be captured in a model with a representative consumer or identical consumers. To capture this effect, this paper analyses models with diverse consumers in a pure-exchange economy without storage. When nominal aggregate demand (NAD) is stochastic but real aggregate supply (RAS) is not, PLT Pareto dominates IT. This is because IT perpetuates price errors and hence nominal aggregate demand errors, while PLT tries to return to the original targeted price path. By perpetuating these errors, IT perpetuates the welfare losses, whereas PLT corrects so to help reduce these welfare losses in the future. When RAS is also stochastic, nominal contracts under NIT can lead to Pareto efficiency when consumers have average relative risk aversion, non-stochastic endowment-to-RAS ratios, and no utility shocks. Under the same assumptions IT and PLT lead to Pareto inefficiencies because they force the payers of nominal contracts to guarantee the real value of those payments to the receivers. In essence this transfers RAS risk from the receivers of the nominal obligations to payers of the nominal obligations. However, this transfer of risk would only be appropriate if all payers of nominal obligations had below average relative risk aversion and all receivers had above average relative risk aversion, a situation that rarely will hold.

Keywords: Pareto efficiency; inflation targeting; price-level targeting; nominal-income targeting; monetary objective function (search for similar items in EconPapers)
JEL-codes: E (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-mon
Date: 2005-12-29
Note: Type of Document - pdf; pages: 22. This uses Pareto efficiency to analyze inflation targeting, price-level targeting, and nominal- income targeting.
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