2 questions for IT fans - InvestingChannel

2 questions for IT fans

This post is aimed at economists who know more about formal monetary models than I do.  I am interested in why so many economists seem to favor inflation targeting, whereas price level targeting seems preferable to me.  I am especially interested in whether the models used to compare these two policy regimes incorporate pertinent facts about the real world.

Models often contain “shocks”, which temporarily throw the economy off course.  One question I have is:

1.  Does the size of shocks in these models depend on the type of monetary regime?

Let me explain with an example.  We are back in June 2008, about to be hit by a severe banking crisis.  In my view the severity of the banking crisis depends to a great extent on whether the central bank is doing growth rate or level targeting.  Under level targeting, investors will expect the economy to bounce back strongly after any severe crisis, and hence asset prices will not fall anywhere near as sharply in the short run.  And with asset prices being more stable, the financial crisis (i.e. the “shock”) will be much milder.

Under level targeting of prices, investors would have expected the price level (PCE) to be about 22% higher in the 10 years after June 2008.  We are now almost 8 years past June 2008, and the price level has rising by 8%.  It looks like it will be about 11% or 12% higher after 10 years, not the 22% expected under level targeting.  Thus under level targeting, investors would have expected a far more expansionary monetary policy over the past 8 years.  That would have made the 2008 financial crisis much milder.  For a recent example of the role of expectations, look at how Brazilian asset prices have been recovering under expectations of impeachment.  Brazil is a mess, but investors are already looking beyond the current inept government.

2.  Is the governing board of the central bank (in these models) split between hawks and doves under inflation targeting, under growth rate targeting, or under both?

There is only one correct answer.  Under IT, central banks are split between hawks and doves, and under level targeting they are not.  Indeed under level targeting the terms “hawk” and “dove” have no meaning.  The only difference is the aggressiveness in which they want to return to the trend line.

Because there is no hawk/dove split under price level targeting, markets have less uncertainty about where the price level will be in the future.  In contrast, under IT you may have some people viewing 2% inflation as a target, and others viewing it as a ceiling.  Or they may differ in terms of whether they’d rather risk erring on the side of too much inflation, or too little.  In contrast, under price level targeting the long run inflation rate is essentially identical regardless of whether the central bank views the target as symmetrical or as a ceiling.

To summarize, I’m asking those who know the literature on IT whether existing models take relevant real world considerations into account.  If not, perhaps someone should create more realistic models.

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