Learning and Misperception: Implications for Price-Level Targeting

Abstract

Monetary policy strategies that target the price level have been advocated as a more effective way to provide economic stimulus in a deep recession when conventional monetary policy is limited by the zero lower bound on nominal interest rates. Yet, the effectiveness of these strategies depends on a central bank's ability to steer agents' expectations about the future path of the policy rate. We develop a flexible method of learning about the central bank's policy rule from observed interest rates that takes into account the limited informational content at the zero lower bound. When agents learn, switching from an inflation targeting to a price-level targeting strategy at the onset of a recession does not yield the desired stabilization benefits. These benefits only materialize after the policy rule has been in place for a sufficiently long time. Temporary price-level targeting strategies are likely to be much less effective than their permanent counterparts.

JEL Classification: E31, E52, E71