Price Level vs. Nominal Income Targeting: Aggregate Demand Shocks and the Cost Channel of Monetary Policy Transmission

This paper incorporates both the traditional aggregate demand-interest rate channel and the cost channel of monetary policy in a baseline ‘new Keynesian’ model and study two targeting regimes --- price-level targeting and nominal income targeting. In light of empirical considerations, alternative specifications for the aggregate demand and aggregate supply side of the economy also considered. The main result is that the cost channel matters: in case of a moderate policy response and with the cost channel operating the volatility of real output decreases under both price-level and nominal income targeting, while it increases in case of an aggressive policy response. The paper also finds that nominal income targeting performs better than price level targeting in bringing down the volatility of real output in almost all the specifications of the macro models used in the analysis.