[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

PRICE LEVEL (P )
INFLATION RATE (π) (%)
when using the rule given by B. Panel B shows the ADI curves under the two different
policy rules, ADI A and ADI B . The full-employment equilibrium is at point E 0 .
Suppose the economy is hit by a temporary inflation shock that increases inflation,
as shown in panel B. An oil price increase or a rise in inflationary expectations
would have this effect. If the central bank’s behavior is described by the policy rule A,
the economy moves to a new short-run equilibrium at point E A . If the
A
central bank’s behavior is described by the policy rule B, the economy
2.5
moves to a new short-run equilibrium at point E B . Under policy rule
2.0
A, output declines more than under policy rule B. The sharper decline
1.5
in output will put greater downward pressure on inflation, leadng inflation
to return to the target more quickly. In the face of inflation shocks,
1.0
0.5
0
the economy will experience more stable inflation and less stable output
–0.5
and employment under policy rule A than under policy rule B. If the central
bank responds less aggressively to inflation (as under rule B), it
–1.0
–1.5
lets inflation fluctuate more but succeeds in keeping output and employment
more stable. This is the trade-off between output stability and
–2.0
–2.5
0 1 2 3 4 5 6 7 8 inflation stability that confronts the central bank.
TIME
In practice, because of the lags between a change in interest rates
and their effects on the economy, central banks must be forwardlooking,
basing interest rate adjustments on expectations about future
B
102.5
inflation. By responding aggressively to changes in expected inflation
(a steep policy rule), monetary policy will limit inflation fluctuations,
but the cost will be greater instability in real output and
102.0
101.5
employment when the inflation adjustment curve shifts. By responding
less aggressively, monetary policy will cause inflation to fluctuate
more when the inflation adjustment curve shifts, but output and
101.0
100.5
employment will be more stable.
100.0
99.5
0 1 2 3 4 5 6 7 8
TIME
Figure 38.4
INFLATION TARGETING VERSUS
PRICE LEVEL TARGETING
The blue line in panel A shows the rate of inflation as
initially equal to zero. In period 2, there is a positive
inflation disturbance, and inflation jumps to 2 percent.
Under a policy of inflation targeting, the central bank tries
to bring inflation back down to zero (shown in the figure
as occurring in period 3). The behavior of the price level
under this policy is shown in panel B. The temporary
increase in inflation leaves the price level permanently
higher than before.
Under a policy of price level targeting, the central bank
would try to bring the price level back to its initial value,
as shown by the green line in panel B. For the price level
to fall, inflation must be negative, as shown in panel A by
the green line.
Price Level Targeting The 1977 amendment to the Federal
Reserve Act established “stable prices,” not stable inflation, as one
of the Fed’s goals. Under a policy of keeping inflation at a low rate,
say, 2 percent per year, the average level of prices continues to rise
from year to year. If the price level rises more rapidly in one year, a
policy of inflation targeting aims to reduce the inflation rate back to
its target level. In contrast, a policy of price level targeting would try
to cause prices to actually fall to bring the average level of prices
back to its targeted level.
The difference between inflation targeting and price level targeting
is illustrated in Figure 38.4. The figure assumes the target inflation
rate is zero but that in period 2 a temporary shock pushes inflation
up to 2 percent for one period, as depicted by the blue line in panel A.
Under inflation targeting, the inflation rate is brought back to zero.
For the sake of simplicity, it is assumed that this occurs in period 3.
Panel B shows what happens to the price level: it jumps to a higher
level in period 2 and then remains permanently higher. Policy brings
inflation back to zero, but no attempt is made to return prices to
their initial level.
854 ∂ CHAPTER 38 CONTROVERSIES IN MACROECONOMIC POLICY