A New Keynesian central bank considers two alternative policies to mitigate the risk of hitting the Zero Lower Bound:
- Raise the inflation target from 2% to 3%.
- Announce a crawling peg exchange rate between the paper money it issues (currency) and the silicon money it issues (reserves), so that paper depreciates at 1% per year relative to silicon, and leave the inflation target at 2% in terms of silicon, which means raising the inflation target to 3% in terms of paper.
Which of those two policies is the best?
The Paper Standard. If firms set prices in terms of paper money, then menu costs (and/or the associated relative price distortions) would be exactly the same under both policies. Because both policies have exactly the same 3% inflation target for prices of goods in terms of paper. The only difference between the two policies is that nominal interest rates paid for holding silicon money would be 1% lower with the second policy than with the first (which doesn't matter). Plus under the second policy there would be the extra hassle of firms and their customers having to translate from posted paper prices into silicon prices if they paid using silicon rather than paper. The first policy is unambiguously better than the second.
The Silicon Standard. If firms set prices in terms of silicon money, then menu costs (and/or the associated relative price distortions) would be lower under the second policy than under the first. Because the second policy has a lower inflation target in terms of silicon. That is one benefit for the second policy. But under the second policy there would be the extra hassle of firms and their customers having to translate from posted silicon prices into paper prices if they paid using paper rather than silicon. That is one benefit for the first policy. Which policy is best depends on the relative sizes of those two benefits.
It is not obvious to me whether the Paper Standard or the Silicon Standard would become the new language for announcing prices, once "paper dollar" and "silicon dollar" mean different things if the second policy is adopted.
[That is a clearer way to draw a policy-relevant conclusion from my previous post. Thanks to commenters, especially JKH.]