Limited commitment, endogenous credibility and the challenges of price-level targeting

Abstract

This paper studies the cost of limited commitment when a central bank commits to a price-level target path but retains the discretion to re-optimize it whenever the cost of honouring its commitment exceeds a tolerance threshold. Such discretion undermines the credibility of the price-level target path and weakens its effectiveness to stabilize the economy. Endogenous target resets are more costly than exogenous target re-optimizations and can give rise to multiple equilibria, including a low credibility equilibrium with frequent target resets and high volatility. Canadian data suggest that price-level target resets could be quite frequent in practice.