1 Aggregate and welfare effects of long run inflation risk under inflation and price-level targeting 1 Michael Hatcher Department of Economics Adam Smith Business School University of Glasgow Glasgow G12 8QQ This version: Jan 2013 Abstract This paper presents a DSGE model in which long run inflation risk matters for social welfare. Aggregate and welfare effects of long run inflation risk are assessed under two monetary regimes: inflation targeting (IT) and price-level targeting (PT). These effects differ because IT implies base-level drift in the price level, while PT makes the price level stationary around a target price path. Under IT, the welfare cost of long run inflation risk is equal to 0.35 per cent of aggregate consumption. Under PT, where long run inflation risk is largely eliminated, it is lowered to only 0.01 per cent. There are welfare gains from PT because it raises average consumption for the young and lowers consumption risk substantially for the old. These results are strongly robust to changes in the PT target horizon and fairly robust to imperfect credibility, fiscal policy, and model calibration. While the distributional effects of an unexpected transition to PT are sizeable, they are short-lived and not welfare-reducing. Keywords: inflation targeting, price-level targeting, inflation risk, monetary policy. JEL Classification: E52 1 The author is grateful for financial support from ESRC postdoctoral fellowship PTA-026-27-2964 and thanks Charles Nolan, Alfred Duncan, Panayiotis Pourpourides and Patrick Minford for helpful comments. Email address for correspondence: michael.hatcher@glasgow.ac.uk.