Targeting the Price Level with Supply Shocks. Suppose the Fed has brought the inflation rate down to zero to stabilize the price level. An adverse supply shock (such as an increase in the world price of oil) now hits the economy.
a. Using the aggregate demand-and-supply model, show how targeting the price level would make the fall in output from the shock greater as compared to no policy at all.
b. Some proponents of price-level or inflation targeting recommend that the Fed target core inflation, which is based on a price index that excludes supply shocks. What is their rationale?