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Good post. When you put it this way, it's a wonder why inflation targeting was chosen in the first place.

I have an additional worry about inflation targeting:
Suppose the price level is constant (sticky prices) and the CB has a 0% inflation target. A drop in NGDP would cause a recession.
Suppose the price level rises at 2% a year ("sticky inflation") and the CB has a 2% inflation target. A drop in NGDP would cause a recession.
The 2% case would be worse for a given drop in NGDP as the price level gets further from the level consistent with output being at potential.

My point is that the CB will not raise NGDP if inflation remains on target (and in the short run it will as that's the rate price setters initially expect ).
Once the inflation rate starts to fall, the CB will react in an expansionary way which will reduce the problem. But this all looks like it will have a greater time lag than NGDP targeting.

Is this a valid objection to inflation targeting?

Iskander: thanks!

I don't think that's a valid objection. Because the central bank is choosing the level of NGDP differently when it decides to target inflation vs target the price level. So we would get a different change in NGDP in each case.


Thought experiments like this are great to help clarify thinking on level targeting, so thanks!

Semi off topic question: what are the open economy implications of price level targeting? It seems to me that two countries with a price level target will effectively have a nominal exchange rate target, which could make for interesting interactions between foreign and domestic mon pol.

John: Hmm. Good question. If Long Run Purchasing Power Parity is true, in levels, then I think you are right. The nominal exchange rate would have to return to its long run value following an aggregate demand shock. But if there are real shocks, the equilibrium real exchange rate would probably change too. So the nominal exchange rate would change too, with both countries holding their price levels constant.

On the other hand, I think price-level targeting might perform worse if the target itself shifts.

Imagine the central bank unexpectedly changes from a fixed price level target to a crawling 1% price level target, or from 0% inflation to 1% inflation.

In each case, simple rational expectations won't cause the price level or inflation to match the target because only 50%+
1/n firms can respond to the announcement. After observing this in one period the central bank will decide to lower interest rates, inferring from below-target inflation/prices that there has been a negative demand shock. Since the PLT central bank needs to correct for the full undershoot, however, it will apply more stimulus than the bygones-inflation bank.

Since a priori demand didn't shift, all central bank action is "incorrect."


> If Long Run Purchasing Power Parity is true, in levels, then I think you are right.

I think that if we have two countries that each perfectly meet price level targets and long-run purchasing power parity is true, then we're necessarily in a world where real interest rate parity is also true. A real-terms shock needs to act symmetrically (perhaps through investment mediation), or it will break either the price level target or purchasing power parity.


"After observing this in one period the central bank will decide to lower interest rates, inferring from below-target inflation/prices that there has been a negative demand shock"

Good point. Take it a step further, in the very period of the demand shock, the central banker notices a bulge in deposits, as do all the member banks in equal error. Under these conditions, each adjustment comes in steps, the step length being a multiples of the error band, the collective 'thermostat' uncertainty. Except in central banking, the assumption is no party has advanced knowledge and interest charges are competitive prices of money already deposited and loaned, ex post. Central banking is a bit different, member banks get better rates but keep regulated and insured. So the restricted members get advanced warning, for a price.

Going to have to disagree on this one Nick. You're making some very heroic assumptions and doing what Keynesians do best: aggregating to triviality a communications process by buyers and sellers (market prices and reactions). To think the recession is over in one period assumes that everybody is on board. Maybe; but it's an assumption not a fact.
The CB loosening "just enough" also assumes that CBs have a clue; also a heroic assumption as shown by real data over the past 50 years everywhere in the world. If it were that easy, we wouldn't need a macroeconomics - just add M or G any time you need it.
I don't think it's that easy at all. I'm skeptical that a CB can handle ANY of the targets properly. Again, support for the skepticism abounds. Little macro-models ain't an economy (btw, this is why we see hysteresis in unemployment figures).
(Still love you though!)

Pete Bias

Pete: thanks!

You are right that I have made heroic assumptions.

But then the Calvo Fairy is also a heroic assumption, because she flies purely at random, so in every period each firm has exactly the same probability of changing its price. And this means that the firms that do change price are a perfectly representative sample of the rest of the population of firms that cannot change price. And the firms that do change price tell us exactly what the firms that cannot change price would do if they could change price.

The other heroic assumption made by standard models is that the central bank responds instantly a shock hits, and the economy responds instantly to the central bank's response. There is zero lag. So stabilisation in response to aggregate demand shocks can be perfect, if the central bank wants it to be.

I have assumed heterogeneity in price flexibility/stickiness. Admittedly, I have assumed a bimodal distribution, with half the firms having perfectly flexible prices, which is extreme heterogeneity. But less extreme than assuming homogeneity.

I have assumed the Central Bank gets it exactly right, but only after a one-period lag. Less extreme than zero lag.

Excellent, this post clarifies a lot of things for me.

I'm going to give you the argument I've always used on NGDPLT, and I'd be curious as to whether you think it's right. One criticism of NGDPLT is that while it would be helpful in a recession, central banks would not want to use level targeting if the economy overheated. The critics claim that if the target were 4%, and NGDP suddenly rose by 6%, then under level targeting you'd have to aim for 2% NGDP growth over the next year. That's true, but where I disagree with the critics is the implication they draw from this fact. They seem to treat the 2% NGDP growth as a sort of recessionary policy. My response is that it would be recessionary if you started from the natural rate of output. But if you have previously just experienced a year of 6% NGDP growth, then the economy has overheated. In that case, a year of 2% NGDP growth actually just brings you back to the natural rate, back to macroeconomic equilibrium.

I think my intuition is similar to yours, but I didn't really know how you'd model it. Your approach seems correct.

Scott: Thanks!

Your argument sounds right to me. Taking the economy down from an unsustainable boom, because output is above the natural rate, because NGDP is above trend, is not the same as creating a recession.

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