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Price Level Targeting with Imperfect Rationality: A Heuristic Approach
Thesis title in Czech: Cílování cenové hladiny s nedokonalou racionalitou: heuristický přístup
Thesis title in English: Price Level Targeting with Imperfect Rationality: A Heuristic Approach
Key words: cílování cenové hladiny, inflační cílování, měnová politika, omezená racionalita, heuristika
English key words: price level targeting, inflation targeting, monetary policy, bounded rationality, heuristics
Academic year of topic announcement: 2018/2019
Thesis type: diploma thesis
Thesis language: angličtina
Department: Institute of Economic Studies (23-IES)
Supervisor: doc. Mgr. Tomáš Holub, Ph.D.
Author: hidden - assigned by the advisor
Date of registration: 23.05.2019
Date of assignment: 12.07.2019
Date and time of defence: 15.09.2020 09:00
Venue of defence: Opletalova - Opletalova 26, O206, Opletalova - místn. č. 206
Date of electronic submission:23.07.2020
Date of proceeded defence: 15.09.2020
Opponents: prof. Roman Horváth, Ph.D.
 
 
 
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Guidelines
During recent decades, inflation targeting has become standard monetary policy regime across developed countries, but there have been ongoing debate regarding its comparison with price level targeting (which, unlike inflation targeting, attempts to compensate for past deviations from the target). As is discussed by Böhm et al. (2012), traditionally there was a perceived trade-off between lower uncertainty regarding future price level (offered by price level targeting) and between lower output and inflation variability (offered by inflation targeting). Nevertheless, Svensson (1999) suggests that under reasonable conditions, inflation variability could be actually lower under PLT than under IT. This result was also supported by subsequent literature (e.g. Clarida et al. (1999)) – theoretical models generally suggest that price level targeting would lead to better results in terms of social welfare than inflation targeting. The compensation for past deviations helps to anchor inflation expectations closer to target, so it is easier to meet the target. On the other hand, no central bank applies price level targeting in practice. The problem is that results of theoretical models are largely driven by rational expectations of all economic agents. Policymakers consider this assumption as too restrictive and they are afraid that in reality, it would be much more difficult to communicate PLT to public, to establish its credibility and to anchor inflation expectations in the way the models suggest. Therefore, this thesis will attempt to address explicitly the role of rationality and of extent to which economic agents are forward-looking. It will be based on aforementioned standard macroeconomic models, but there will be a friction in rationality, so that inflation expectations will not be formed in perfectly rational way. This should offer new insight into comparison of inflation to price level targeting, which should be closer to reality than results suggested by models using rational expectations hypothesis.

There is only small number of papers which investigates price level targeting with some imperfections in rationality of agents and credibility of the regime (Honkapohja and Mitra (2018) or Gino and Malik (2018) are two examples), and to my best knowledge none of them focuses on the Czech Republic. Therefore the thesis should bring more realistic comparison of currently used inflation targeting and its alternative, price level targeting; and it should suggest whether price level targeting is a viable option for monetary policymaking in Czech conditions.

1. Hypothesis #1: In standard model with characteristics of the Czech Republic and with assumption of perfect rationality, price level targeting leads to better outcome in terms of economic stability and social welfare than inflation targeting.
2. Hypothesis #2: Abandoning rational expectations assumption decreases attractivity of price level targeting, where the higher the deviation from rational expectations hypothesis, the worse is performance of the price level targeting.
3. Hypothesis #3: When zero lower bound is considered, strength of price level targeting is higher than in normal conditions (even without fully rational expectations).
References
BÖHM, J., J. FILÁČEK, I. KUBICOVÁ, AND R. ZAMAZALOVÁ. (2012): “Price-Level Targeting – A Real Alternative to Inflation Targeting?” Czech Journal of Economics and Finance, 62(1), pp. 2–26.
CLARIDA, R., J. GALI, AND M. GERTLER (1999): “The Science of Monetary Policy: A New Keynesian Perspective.” Journal of Economic Literature No. 37, pp. 1661–1707.
GALÍ, J. (2015): “Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications.” Second edition. Oxford: Princeton University Press. ISBN 978-0-691-16478-6.
CATEAU, G. AND M. SHUKAYEV. (2018): "Limited Commitment, Endogenous Credibility and the Challenges of Price-level Targeting." Staff Working Papers, pp. 18-61, Bank of Canada.
HONKAPOHJA, S. AND K. MITRA. (2018): "Price Level Targeting with Evolving Credibility." CEPR Discussion Papers 12739.
MILANI, F. (2012): "The Modeling of Expectations in Empirical DSGE Models: a Survey." Working Papers 121301, University of California-Irvine, Department of Economics.
SVENSSON, L. (1999): “Price-Level Targeting versus Inflation Targeting: A Free Lunch?” Journal of Money, Credit and Banking, 31(3), pp. 277-295.
Preliminary scope of work in English
The core approach will be DSGE model, which is a standard tool in macroeconomic modelling. The model will be focused on the Czech Republic, although its results should be in general applicable also to other countries (at least to those with characteristics similar to the Czech Republic). The main deviation from classic DSGE models will be a friction in rationality, so that inflation expectations will no longer be formed with complete rationality – adaptive learning will be utilized instead (literature regarding this topic is summarized e.g. by Milani (2012)). Results of price level targeting in such model will then be compared with inflation targeting, where output and inflation variability will be the key measures of performance of the two monetary policy regimes. The comparison will be conducted under normal economic circumstances and at zero lower bound on interest rates.

Outline:

1. Introduction
2. Theoretical background, literature review (comparison of PLT and IT in the literature, role of rational expectations and of extent to which economic agents are forward-looking)
3. Methodology – DSGE model (description of basic model and approach to modelling imperfect rationality in formation of expectations)
4. Results (comparison of PLT and IT based on the model results)
5. Discussion, robustness assessment
6. Conclusion
 
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