Price Level Targeting with Imperfect Rationality: A Heuristic Approach

The paper compares price level targeting and inflation targeting regimes in a New Keynesian model with bounded rationality. Economic agents form their expectations using heuristics - they choose between a few simple rules based on their past forecasting performance. In the paper, two main specifications of the price level targeting model are examined - the agents form expectations either about the price level or about inflation, which is ex ante not equivalent because of the sequential nature of the model. In addition, several formulations of the forecasting rules are considered. Both regimes are assessed by performing a loss function comparison. According to the results, price level targeting is slightly preferable in case where expectations are created about the price level under the baseline calibration. It is, however, sensitive to some model parameters and there is a risk of instability. Furthermore, when expectations are created about inflation, price level targeting loses credibility over time and leads to divergence of the economy. On the other hand, inflation targeting model functions in a stable manner. Therefore, while the potential benefits of price level targeting have been confirmed under certain assumptions, the results suggest that inflation targeting constitutes a more robust choice for monetary policy.