Scandinavian Working Papers in Economics

Discussion Paper Series in Economics,
Norwegian School of Economics, Department of Economics

No 22/2018: On the perils of stabilizing prices when agents are learning

Antonio Mele (), Krisztina Molnar () and Sergio Santoro ()
Additional contact information
Antonio Mele: University of Surrey, Postal: Surrey, UK
Krisztina Molnar: Dept. of Economics, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Economics, Helleveien 30, N-5045 Bergen, Norway
Sergio Santoro: Bank of Italy, Postal: Rome, Italy

Abstract: The main advantage of price level stabilization compared with inflation stabilization rests on the central bank's ability to shape expectations. We show that stabilizing prices is no longer optimal when the central bank can shape expectations of agents with incomplete knowledge, who have to learn about the policy implemented. Disinating in the short run more than agents expect generates short-term gains without triggering an abrupt loss of confidence, because agents update expectations sluggishly. Following this policy, in the long run, the central bank loses the ability to shape agents' beliefs, and the economy converges to a rational expectations equilibrium in which policy does not stabilize prices, economic volatility is high, and agents su er the corresponding welfare losses. However, these losses are outweighed by short-term gains from the learning phase.

Keywords: Price; stabilization

JEL-codes: C62; D83; D84; E52

35 pages, October 26, 2018

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