WELFARE IMPLICATIONS

1
WELFARE IMPLICATIONS

• The Welfare Implications of Inflation vs. Price
  Level Targeting in a Two/Sector, Small Open
  Economy by Eva Ortega and Nooman Rebei
• Learning and Welfare Implications of Changing
  Inflation Targets by Kevin Moran
• Discussion by Vítor Gaspar

2
The two papers have a lot in common

• Challenging and ambitious papers.
• New Keynesian Framework.
• Monetary Policy characterized by a Taylor rule
  (parameters in instrument rules interpreted as
  target variables).
• Welfare gains measured by the consumption
  compensating variation for the representative
  consumer.
• Decisions on calibration (e.g. the real interest
  rate at 4 per cent).

3
Some important differences

• Open economy
• Tradables, Non-tradables, imports
• Eight shocks
• Money in the utility function

• Closed economy
• One final goods sector
• One shock (to monetary policy)
• Cash-in-advance constraint

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A FUNDAMENTAL PROBLEM

• From David Hume

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HUMES PRINCIPLE - ONE CANNOT INFER OUGHT FROM
IS
When of a sudden I am surprised that instead of
the usual copulation of propositions, is and is
not, I meet with no proposition that is not
connected with an ought or an ought not a
reason should be given, for what seems altogether
inconceivable, how this new relation can be a
deduction from others, which are entirely
different from it. David Hume, A Treatise of
Human Nature, Book III, Part 1, section 1
6
The papers have something else in common

• They look at important policy questions
• Should monetary policy target inflation or the
  price level?
• Should the inflation target be 2 or 0?

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PRICE LEVEL TARGETING VS INFLATION TARGETING
8
The Simple Model Closed Economy Model
The basic equation a new Keynesian Phillips
curve

i.i.d
Where
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The Simple Model

Social Welfare



0.99 0.5
0.05 0.07
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Discretion and commitment under rational
expectations
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Discretion and commitment under rational
expectations
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Discretion and commitment under rational
expectations

• Basic idea of commitment (Clarida, Gali and
  Gertler (1999) and Woodford (2003))
• Under RE expectations provide an intertemporal
  link that allows spreading the effects of shocks
  over time
• Under commitment expectations operate as
  automatic stabilisers
• In our simple example
• after a cost-push shock inflation expectations
  should fall thereby reducing the immediate impact
  of the shock
• this can be achieved through a gradual but
  persistent output gap
• leading to inflation undershooting.

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WHAT TARGET FOR INFLATION?

• 2 OR 0?

14
What are the relevant arguments from the
literature?

• Transactions costs
• Distortionary taxes
• Price-setting, monopolistic competition, nominal
  frictions
• Wage-setting, labor market frictions
• Deflation and the zero bound
• Measurement issues

• Friedman rule
• Zero or negative inflation
• Zero inflation
• ?
• 2 provides sufficient buffer
• Low (but positive) inflation

15
What is the value added from the paper by Kevin
Moran?

• In a model where moving from 2 to 0 inflation
  leads to welfare gains the paper shows that those
  gains are significantly reduced by taking into
  account transition dynamics
• It provides of good example of the importance of
  modeling the dynamics of regime change.

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Regime change and the Lucas critique the end of
the Great Inflation in the US
Explosive dynamics with and without regime
change,
p
t
0.5
0.4
0.3
0.2
0.1
0
-0.1
-0.2
0
100
200
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400
500
600
700
800
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Regime change and the Lucas critique the end of
the Great Inflation in the US
Explosive dynamics with and without regime change
1.5
1
0.5
0
0
100
200
300
400
500
600
700
800
18
Regime change and the Lucas critique the end of
the Great Inflation in the US
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Regime change and the Lucas critique the end of
the Great Inflation in the US

• Sophisticated central banking sees the need to
  open a significant output gap in order to deliver
  inflation consistently below expectations
• delivering gradual anchoring of inflation and
  inflation expectations
• after a long transition the difference in the
  output gap path is no longer visible
• in the fullness of time we have seen that
  sophisticated CB delivers better performance (in
  terms of inflation and the output gap)

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WELFARE IMPLICATIONS

• The Welfare Implications of Inflation vs. Price
  Level Targeting in a Two/Sector, Small Open
  Economy by Eva Ortega and Nooman Rebei
• Learning and Welfare Implications of Changing
  Inflation Targets by Kevin Moran
• IMPORTANT CONTRIBUTIONS TO A VERY DIFFICULT BUT
  IMPORTANT FIELD