Maintaining price stability: how long is the medium term?

Using a small estimated forward looking model of the euro area economy, this paper analyses the determinants of the optimal monetary policy horizon for maintaining price stability. First, the optimal policy horizon for a price level objective is generally longer than that for an inflation objective. Second, the policy horizon becomes longer, the greater the weight on other objectives like minimising output gap and interest rate variability. Third, the optimal policy horizon is shorter, the higher the degree of “forward-lookingness” in the economy and the greater the slope of the Phillips curve. Finally, even if society cares only about inflation stabilisation, it often pays to give the central bank a price level objective, provided the horizon is optimally chosen to be somewhat longer.