Price Level Targeting

Definition

Price level targeting is a monetary policy strategy where a central bank aims to maintain a specific price level over time, stabilizing the overall price level rather than just focusing on inflation rates. This approach helps to create a predictable economic environment, encouraging investment and consumption by anchoring expectations about future prices. It relates closely to other monetary frameworks such as the Taylor Rule and strategies for nominal GDP targeting.

5 Must Know Facts For Your Next Test

1. Price level targeting can help avoid the problem of price-level shocks affecting real economic activity, as it aims to stabilize prices over the long term.
2. Under this framework, if there is an unexpected rise in prices, the central bank would adjust its policies to ensure that the price level returns to its target trajectory.
3. This approach contrasts with inflation targeting, which focuses on managing inflation rates without directly addressing the overall price level.
4. Price level targeting is thought to provide better economic stability during periods of economic uncertainty or after significant economic shocks.
5. One potential drawback is that it may require more aggressive monetary policy responses to price fluctuations, which could lead to increased volatility in interest rates.

Review Questions

• How does price level targeting differ from traditional inflation targeting in terms of economic objectives?
  • Price level targeting differs from traditional inflation targeting by focusing on stabilizing the overall price level instead of just managing inflation rates. While inflation targeting aims for a specific inflation rate, often reacting to current inflation data, price level targeting seeks to maintain a predetermined price level over time. This means that if prices rise above target levels, the central bank will adjust policies to bring them back down, rather than simply accommodating higher inflation temporarily.
• Discuss the potential advantages of implementing price level targeting as opposed to other monetary policy frameworks like nominal GDP targeting.
  • Implementing price level targeting can provide several advantages compared to frameworks like nominal GDP targeting. For one, it creates a clear and stable anchor for expectations about future prices, which can encourage investment and consumption. Additionally, by focusing on the overall price level rather than GDP fluctuations, this strategy may help avoid excessive volatility in real economic activity during periods of economic stress. However, it requires careful calibration of monetary policy tools to effectively respond to price shocks and achieve desired outcomes.
• Evaluate how price level targeting could impact a central bank's response to an economic crisis compared to approaches like the Taylor Rule.
  • In an economic crisis, a central bank employing price level targeting might adopt more aggressive monetary policy measures compared to using the Taylor Rule. The rationale behind this is that price level targeting aims to restore the predetermined price path rather than simply responding to current inflation and output levels as suggested by the Taylor Rule. This could lead to lower interest rates or unconventional measures aimed at preventing deflationary spirals and stabilizing the economy. However, while this may provide short-term relief, it also risks long-term consequences such as asset bubbles if not managed carefully.

Related terms

Inflation Targeting: A monetary policy strategy where a central bank sets a specific inflation rate as its primary goal, using interest rate adjustments to steer the economy toward that target.

Nominal GDP Targeting: A monetary policy framework aimed at stabilizing the growth of nominal Gross Domestic Product (GDP) by adjusting monetary policy in response to changes in GDP growth rates.

Taylor Rule: A formula that provides guidance on how central banks should change interest rates in response to changes in inflation and economic output.