Monetary-fiscal interactions under price level targeting

TL;DR

This paper explores how monetary and fiscal policies interact under price level targeting, showing that it can help avoid the zero lower bound and improve welfare during demand shocks.

Contribution

It provides a novel analysis of monetary-fiscal interactions under price level targeting, highlighting benefits like avoiding the zero lower bound and welfare improvements.

Findings

Central bank increases policy rate after demand shock

Price level targeting helps avoid zero lower bound

Welfare improves under price level targeting compared to inflation targeting

Abstract

The adoption of a "makeup" strategy is one of the proposals in the ongoing review of the Fed's monetary policy framework. Another suggestion, to avoid the zero lower bound, is a more active role for fiscal policy. We put together these ideas to study monetary-fiscal interactions under price level targeting. Under price level targeting and a fiscally-led regime, we find that following a deflationary demand shock: (i) the central bank increases (rather than decreases) the policy rate; (ii) the central bank, thus, avoids the zero lower bound; (iii) price level targeting is generally welfare improving if compared to inflation targeting.