It is particularly appropriate to overshoot the target when unemployment is higher than its long-run sustainable rate, as it can then reach its long-run sustainable rate sooner. The usual way of applying the current inflation target entails that even if the target is undershot over a period of time the central bank still endeavours to maintain inflation in line with the target. Thus the central bank does not attempt to compensate for the previously low inflation with a period when inflation is above the target. To ensure that average inflation is on target over a longer period of time, the central bank could instead have a so-called price level target that means the price level should be stabilised around a price level path that rises by 2 per cent a year. Such a price level target would mean that average inflation is at 2 per cent over a longer period of time. The advantages and disadvantages of a price level target have been discussed at length in academic literature (see for instance Bank of Canada 2011). Since a downward-sloping long-run Phillips curve makes it important to keep average inflation over a longer period of time on target, this strengthens the arguments in favour of a price level target. A less dramatic change would be a target in the form of a moving average of inflation over a longer period of time, for instance five or ten years (Nessén and Vestin 2005).
The high level of indebtedness built up during the economic upturn in many countries significantly increased this risk. Positive expectations of the future had increased companies' financing needs for investment. At the same time, a bright picture painted of the future and an increase in wealth had stimulated households' consumption and increased their investment in housing. It was easy to imagine a risk scenario where household sector demand declined so rapidly that heavily indebted companies went bankrupt, where unemployment rose drastically and where banks an other lenders suffered extensive loan losses. This negative spiral could continue with further falls in share prices and household wealth and rising credit risk premiums would make lending more expensive. If this negative sequence of events were not broken, high loan losses could eventually lead to bank crises and credit crunches, which would contribute further to the downward spiral. A credit boom, large increases in asset prices and a high rate of growth in investment, often concentrated on a particular sector, have been the factors preceding serious financial crises around the world. However, it is important to remember that neither a credit boom nor a large deficit on the current account need be interpreted as an accumulation of financial imbalances. If savings and investment decisions are based on realistic expectations of future growth and banks and financial investors have been able to make realistic assessments of the credit risks connected with investment projects and consumption loans, then this development is more a sign that the international capital markets are functioning efficiently.