Stabilization Policy, Rational Expectations and Price-Level Versus Infl‡ation Targeting: A Survey

40 Pages Posted: 2 Jun 2014

See all articles by Michael Hatcher

Michael Hatcher

Cardiff University

Patrick Minford

Cardiff University Business School; Centre for Economic Policy Research (CEPR)

Date Written: February 2014

Abstract

We survey recent literature comparing inflation targeting (IT) and price-level targeting (PT) as macroeconomic stabilization policies. Our focus is on New Keynesian models and areas which have seen significant developments since Ambler’s (2009) survey: the zero lower bound on nominal interest rates; financial frictions; and optimal monetary policy. Ambler’s main conclusion that PT improves the inflation-output volatility trade-off in New Keynesian models is reasonably robust to these extensions, several of which are attempts to address issues raised by the recent financial crisis. The beneficial effects of PT therefore appear to hang on the joint assumption that agents are rational and the economy New Keynesian. Accordingly, we discuss recent experimental and survey evidence on whether expectations are rational, as well as the applied macro literature on the empirical performance of New Keynesian models. In addition, we discuss a more recent strand of applied literature that has formally tested New Keynesian models with rational expectations. Overall the evidence is not conclusive, but we note that New Keynesian models are able to match a number of dynamic features in the data and that behavioral models of the macroeconomy are outperformed by those with rational expectations in formal statistical tests. Accordingly, we argue that policymakers should continue to pay attention to PT.

Keywords: inflation targeting, price level targeting, Rational Expectations

JEL Classification: E31

Suggested Citation

Hatcher, Michael and Minford, Patrick, Stabilization Policy, Rational Expectations and Price-Level Versus Infl‡ation Targeting: A Survey (February 2014). CEPR Discussion Paper No. DP9820. Available at SSRN: https://ssrn.com/abstract=2444821

Michael Hatcher (Contact Author)

Cardiff University ( email )

Aberconway Building
Colum Drive
Cardiff, Wales CF10 3EU
United Kingdom

Patrick Minford

Cardiff University Business School ( email )

Aberconway Building
Colum Drive
Cardiff, CF10 3EU
United Kingdom
+44 29 2087 5728 (Phone)
+44 29 2087 4419 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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