Upgrade Economics: Price Level Targeting

William Wu

The foundations of science were recently shaken as it was discovered that particles can go faster than the speed of light.

The change is forcing the scientific community to go back to the drawing board. Effectively, it’s time to challenge Albert Einstein. If such a hard science was shaken by her core, without a doubt it is time to update the field of Economics.

Although contrary to popular belief Adam Smith  did not champion truly unregulated (free) markets. Regardless, it’s the goal of Mindthis to start a serious dialogue with the perceived status quo of Adam Smith and traditional economics.

I wanted to bring in a young professional who is not only an expert on monetary policy but a well rounded individual grounded in economic theory and actual work experience in the field. 

William Wu (Bill) is a law student at University of Toronto Faculty of Law, while concurrently pursuing a masters degree in Economics. Originally from China, Bill has an intimate knowledge of the economic and political conditions in China. He also holds an undergraduate degree in Honours Economics from the University of British Columbia, thus becomes our link between Canada and China. He has worked at the International Department of the Bank of Canada in a research capacity, where he gained extensive knowledge of the inner workings of monetary policy making. Bill is going to be apart of the team that will redefine economics in the lenses of young professionals. 

We start with Monetary Policy.


Cutting edge of Monetary Policy: Price-Level Targeting (PLT) 


Earlier in November 2011, the Bank of Canada renewed its monetary policy framework with the Canadian government, reaffirming its commitment to target annual inflation rate at 2 per cent. Canada’s experience with inflation targeting (IT) has been very successful since its adoption in 1991. As a part of the renewal process, the Bank of Canada assessed various possible changes to its monetary policy frame in order to improve on its success. One such change contemplated was price-level targeting (PLT). PLT has yet to be adopted by any central banks in the world.

Under IT, if the inflation rate moves above the targeted level, all the central bank needs to do is to bring it back to the target level. Suppose the targeted level is 2 per cent. If the inflation rate stays above 2 per cent for an extended period, the central bank can declare victory by simply bringing it down to 2 per cent. But the problem is, the long term average inflation rate would be above the targeted level of 2 per cent.

Solution: Price Level Targeting 

PLT aims to target an average rate of change in the price level. This may sound similar to IT, but it has an important difference. Again suppose the targeted level is 2 per cent. If the inflation rate persists at above 2 per cent, the central bank cannot declare victory by simply bringing it down to 2 per cent. It must bring the inflation rate down to below 2 per cent for a period then back to 2 per cent, so that the long run average rate would be 2 per cent. As is commonly known in the field, bygones are not bygones under PLT.

The purpose of having a target is to anchor people’s expectation about price. With a credible announcement by the central bank that it is committed to a target of 2 per cent, consumers and investors may expect that inflation rate will indeed be 2 per cent in the future. This expectation helps them make better decisions about the future, such as how much to save and invest. The central bank’s success in achieving its target makes people’s expectation about the future more accurate, which in turn improves their saving and investing decisions.

As I have illustrated, under IT, the targeted inflation rate may not reflect the long run average rate very well. PLT is supposed to improve on this aspect, by targeting the long run average rate. But the trade-off is that PLT may yield more inflation volatility in the short term, because a period of higher-than-target inflation must be offset by a period of lower-than-target inflation and vice versa.

The success of any target regime hinges on whether people believe the commitment the central bank makes. In one respect, this reflects the central bank’s credibility. Central banks in most developed countries, such as Bank of Canada, European Central Bank, Swiss Nation Bank, etc., are very trusted institutions; whereas, hardly anyone trusts the central bank of Argentina.

Another aspect deals with how people’s expectations are formed. PLT may be better than IT only if people actually form expectations about long term inflation averages. People must believe that the central bank will push the inflation rate to below the target in order to rectify the above-target levels of the past periods. No one is quite sure if people will actually believe it. Furthermore, we don’t know how people’s expectation may change as we move from IT to PLT. It is certainly a possibility that the confusion during the transition period may offset any potential benefits of PLT.

This time, the Bank of Canada was not confident enough to be first one in the world to adopt PLT. These are questions of active cutting edge economics research in academia and central banks around the world. In fact, to properly answer these questions, we need to import insights from behavioural psychology and other disciplines. This is one area of economics research that may have quite important and far-reaching implications in the real world.