Is Time Ripe for Price Level Path Stability?

44 Pages Posted: 2 Nov 2007

See all articles by Vítor Gaspar

Vítor Gaspar

Bank of Portugal

Frank Smets

European Central Bank (ECB); KU Leuven - Center for Economic Studies

David Vestin

European Central Bank (ECB)

Date Written: October 2007

Abstract

In the paper, we provide a critical and selective survey of arguments relevant for the assessment of the case for price level path stability (PLPS). Using a standard hybrid new Keynesian model we argue that price level stability provides a natural framework for monetary policy under commitment. There are two main arguments in favour of a PLPS regime. First, it helps overall macroeconomic stability by making expectations operate like automatic stabilizers. Second, under a price level path stability regime, changes in the price level operate like an intertemporal adjustment mechanism, reducing the magnitude of required changes in nominal interest rates. Such a property is particularly relevant as a means to alleviate the importance of the zero bound on nominal interest rates. We also review and discuss the arguments against price level path stability. Finally, we also found, using the Smets and Wouters (2003) model which includes a wide variety of frictions and is estimated for the euro area, that the price level is stationary under optimal policy under commitment. The results obtain when the quasi- difference of inflation is used in the loss function, as in the hybrid new Keynesian model. Overall, the arguments in favour of or against price level path stability depend on the degree of dependence of private sector expectations on the characteristics of the monetary policy regime.

Keywords: Price Level Stability, Expectations, Adaptive Learning

JEL Classification: E52, D83

Suggested Citation

Gaspar, Vítor and Smets, Frank and Vestin, David, Is Time Ripe for Price Level Path Stability? (October 2007). ECB Working Paper No. 818, Available at SSRN: https://ssrn.com/abstract=1015270 or http://dx.doi.org/10.2139/ssrn.1015270

Vítor Gaspar (Contact Author)

Bank of Portugal ( email )

Rua Francisco Ribeiro, 2
Lisbon, 1150-165
Portugal

Frank Smets

European Central Bank (ECB) ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany
+49 69 1344 6550 (Phone)
+49 69 1344 6575 (Fax)

KU Leuven - Center for Economic Studies ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

David Vestin

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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