Price Level Targeting and Stabilization Policy

We construct a dynamic stochastic general equilibrium model to study optimal monetary stabilization policy. Prices are fully ‡exible and money is essential for trade. Our main result is that if the central bank pursues a price-level target, it can control in‡ation expectations and improve welfare by stabilizing short-run shocks to the economy. The optimal policy involves smoothing nominal interest rates which e¤ectively smooths consumption across states. We have received many bene…cial comments from many people. In particular, we want to thank Gaudi Eggertsson and the participants of the Liquidity in Frictional Markets conference at the FRB-Cleveland, November 14-15, 2008. Much of the paper was written while Berentsen was visiting the University of Pennsylvania. We also thank the Federal Reserve Bank of Cleveland, the CES in Munich and the Kellogg Institute at the University of Notre Dame for research support. The views expressed are those of the individual authors and do not necessarily re‡ect o¢ cial positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors.