October 1999
Abstract
The paper discusses several issues related to how monetary
policy should be conducted in an era of price stability. Low
inflation (with base drift in the price level) and price-level
stability (without such base drift) are compared, and a suitable
loss function (corresponding to flexible inflation targeting) is
discussed, including the index and level for the inflation target.
Three ways of maintaining price stability are examined, namely (1)
a commitment to a simple instrument rule, (2) "forecast
targeting," and (3) monetary targeting. Both (1) and (3) are
found to be inferior to forecast targeting. The benefits of
credibility (private inflation expectations coinciding with the
inflation target) are discussed. Credibility improves the
tradeoff between inflation variability, output-gap variability
and instrument variability and makes it easier for the central
bank to meet is inflation target. The threat of deflation and a
liquidity trap is examined. Transparent inflation targeting and a
contingency plan with emergency measures, including a coordinated
fiscal and monetary expansion, are likely to avoid a liquidity
trap, but also contribute to escaping from one if already trapped.
JEL classification: E42, E52, E58
Keywords: Credibility, deflation, inflation target, liquidity trap, price-level targeting