Inflation Targeting versus Price-Level Targeting under Hysteresis: A New Keynesian Analysis

Absztrakt (kivonat)

The primary aim of my thesis is to compare two common monetary policy rules: inflation targeting and price level targeting, from a welfare point of view. The New Keynesian model framework will construct the baseline, which will be extended with hysteresis. My research question is to assess the performance of the two monetary policies under the basic model and under the model incorporating hysteresis. In economics, hysteresis is a phenomenon where a transitory shock exerts a permanent effect on the long-term equilibrium of a system. It has been proven to be able to explain high persistence in output, though its implications are widely overlooked. The New Keynesian model framework will be used as the baseline, which will be extended with hysteresis in the hope of achieving a model that better replicates the patterns seen in empirics. Two types of monetary policy rules will be applied, inflation targeting and price level targeting. To measure and assess the performance of the two monetary policy rules, an ad hoc social welfare loss function will be used, which quantifies the utility losses experienced by households during deviations from the optimal allocation. My results indicate that price-level targeting is a better policy alternative than inflation targeting, as it showed better control over inflation and output variability under technology and demand shocks. However, the case of markup shock was less clear. While price-level targeting restricted inflation’s variability better in all cases, its relative efficacy in curtailing output gap’s volatility depended on the level of hysteresis.