Forward Guidance at the Zero Lower Bound in a Model of Price-Level Targeting

We study monetary policy at the ZLB in a traceable three-period
model, in which price-level targeting emerges endogenously in the
welfare function. We characterize optimal price-level forward
guidance under discretion and commitment. Potentially non-monotonic
discretionary welfare losses are lowest with perfectly flexible
prices. Price-level targeting introduces a new constraint on
optimal forward guidance that restricts the credible amount of
overshooting. With this constraint, the zero lower bound may be
binding even after the shock has abated. We characterize conditions
when the commitment to hold nominal rates at zero for an extended
period is optimal. Finally, we introduce government spending and
show that under persistently low policy rates optimal government
spending becomes more front-loaded, while procyclical austerity
fares worse than discretionary government spending.