Adopting Price-Level Targeting under Imperfect Credibility

Authors' note: After completing this working paper, we realized a computer coding error, which led to an overstatement of transition costs due to imperfect credibility. The corrected results show that it takes at least 10 quarters of low credibility (as opposed to 2 quarters in the old version) for a policy change from inflation targeting to price-level targeting to be welfare reducing. The revised version of this paper with corrected transition costs is forthcoming as a Bank of Canada Working Paper.

This paper measures the welfare gains of switching from inflation-targeting to price-level targeting under imperfect credibility. Vestin (2006) shows that when the monetary authority cannot commit to future policy, price-level targeting yields higher welfare than inflation targeting. We revisit this issue by introducing imperfect credibility, which is modeled as gradual adjustment of the private sector's beliefs about the policy change. We find that gains from switching to pricelevel targeting, if any, are small.