Price Stability Under Long-Run Monetary Targeting

P rice-level stability is widely recognized as the principal goal of monetary policy (see, for example, Black 1990, Carlstrom and Gavin 1991, and Hoskins 1991). A program for price stability actually has two distinct objectives; achieving each objective has its own distinct benefits. The first objective is to reduce the expected rate of price inflation to zero. The second objective is to eliminate uncertainty about long-run changes in the price level. When these two objectives are met, monetary policy ceases to have disruptive effects in the real economy and in financial markets. A simple model of the demand for money, such as the inventory model presented by Barro (1984), indicates that a rate of inflation that is expected to be positive provides consumers and firms with an incentive to engage in costly cash management activities in order to economize on their money holdings. In addition, because the federal income tax system is not completely indexed for changes in the price level, a positive rate of inflation causes some tax rates to increase automatically over time (Altig and Carlstrom 1991). Under zero inflation, costly cash management activities are unnecessary and unlegislated tax increases do not occur. These are the benefits of achieving the first objective of price stability.