Seminar Papers, Institute for International Economic Studies, Stockholm University
How Should Monetary Policy Be Conducted in an Era of Price Stability
Abstract: The paper discusses several issues related to how monetary
policy should be conducted in an era of price stability. Low inflation
(with base drift in the price level) and price-level stability (wihtout
such base drift) are compared, and a suitable loss function (corresponding
to flexible inflation targeting) is discussed, including the index and
level for the inflation target. Three ways of maintaining price stability
are examined, namely (1) a commitment to a simple instrument rule, (2)
"forecast targeting" and (3) monetary targeting. Both (1) and (3) are found
to be inferior to forecast targeting. The benefits of credibility (private
inflation expectations coinciding with the inflation target) are discussed.
Credibility improves the tradeoff between inflation variability, output gap
variability and instrument variability and makes it easier for the central
bank to meet its inflation target. The threat of inflation and a liquidity
trap are examined. Transparent inflation targeting and a contingency plan
with emergency measures, including a coordinated fiscal and monetary
expansion, are likely to avoid a liquidity trap, but also contribute to
escaping from one if already trapped.
Keywords: credibility; deflation; inflation target; liquidity trap; price-level targeting; (follow links to similar papers)
JEL-Codes: E42; E52; E58; (follow links to similar papers)
59 pages, October 1, 1999
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