Working Paper no. 135
By Nicoletta Batini and Anthony Yates
The previous literature on the benefits of price level versus inflation targeting has, with some qualifications, established that price level targeting entails lower price level variance at the expense of higher inflation and output variance. In this paper we investigate the properties of monetary regimes that combine price level and inflation targeting. We offer two characterisations of these regimes: a set of optimal control rules obtained assuming that policy-makers minimise a loss function that penalises a mixed price level/inflation target; and a set of simple rules feeding back from alternative combinations of (current and future-dated) price level and inflation deviations from target. We derive asymptotic variances of the price level, inflation and output associated with each of these regimes when the economy is modelled as a small-scale open-economy RE model calibrated on UK data. We conclude that: (i) the relative merits of price level and inflation targeting, as well as of mixes of these two, are a function of several modelling and policy assumptions; and (ii) these merits do not change monotonically as we move from one regime to another. It appears also that the probability of nominal interest rates hitting a ‘zero bound’ under the alternative regimes is model-specific and varies non-monotonically among them.