Monetary Policy Under Alternative Interest-Rate Rules


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In recent years several studies have focused on the potential benefits of conducting monetary policy by setting a target for the path of the price level rather than a target for the rate of inflation. This research has shown that, unlike previous studies suggested, price-level targeting may be able to achieve a better trade-off between inflation and output volatility. This paper focuses on the implications of price-level targeting for exchange rate dynamics. Using a small open economy model calibrated to match Canadian data, I find that a central bank with a price-level target may be able to reduce the volatility of the nominal exchange rate, but the effect on the real exchange rate depends on the type of shocks faced by the economy. Demand shocks generate less real exchange rate volatility under price-level targeting than under inflation-targeting, but the opposite is true for supply shocks. The results indicate that in Canada a price-level target would have generated much less inflation volatility but slightly higher real exchange rate volatility than its current inflation targeting regime.

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