Price-level targeting rules and financial shocks: The case of Canada

How important are the benefits of low price-level uncertainty in the presence of financial shocks? This paper explores the desirability of price-level path targeting in a small open economy with credit frictions à la Bernanke et al. (1999). The model features credit flows and exogenous shocks that originated in both domestic and international credit markets. Financial shocks, exacerbating the distortion generated by the debt-deflation channel, provide a rational for an interest-rate response to the price-level. Indeed, a price-level targeting rule reduces the trade-off between the nominal debt distortion and the inefficiency generated by nominal price stickiness. The policy implications are based on social welfare evaluations. Parameter's uncertainty does not significantly affect the main results. ► This paper assesses the benefits of price-level targeting. ► The model includes both domestic and international financial shocks. ► It features both nominal debt and nominal price rigidity distortions. ► There is a trade-off between the two distortions. ► Under the price-level targeting the trade-off is more favorable.