Published online by Cambridge University Press: 30 May 2016
I compare nominal gross domestic product (GDP) level targeting with strict price level targeting in a small New Keynesian model, with the central bank operating under optimal discretion and facing a zero lower bound on nominal interest rates. I show that, if the economy is only buffeted by purely temporary shocks to inflation, nominal GDP level targeting may be preferable because it requires the burden of the shocks to be shared by prices and output. However, in the presence of persistent supply and demand shocks, strict price level targeting may be superior because it induces greater policy inertia and improves the tradeoffs faced by the central bank. During lower bound episodes, somewhat paradoxically, nominal GDP level targeting leads to larger falls in nominal GDP.
I thank for valuable comments Bill English, Bob Hall, Keith Kuester, Scott Sumner, Carl Walsh, seminar participants at Danmarks Nationalbank, Sveriges Riksbank, and University of Glasgow Adam Smith Business School, as well as conference participants at CEF, EEA, and NASM. The views expressed herein are solely the responsibility of the author and should not be interpreted as reflecting the views of Sveriges Riksbank.