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Targeting inflation by forecast feedback rules in small open economies

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  • Leitemo, Kai

Abstract

We argue that inflation-targeting strategy in practice can be approximated with the interest rate responding to the unchanged-interest-rate forecast of inflation. We develop a method to derive unchanged-interest-rate forecasts in forward-looking models and evaluate the performance of the policy rule in an optimizing New Keynesian model due to Monacelli (2003) estimated on UK data. We find that the policy rule is less prone to generate a determinate rational expectations equilibrium if based on an unchanged interest rate compared to the rule-consistent forecast. The rule approximates the optimal commitment policy if the central bank attaches sufficient weight to inflation as opposed to output gap stabilization. The optimal forecast horizon is robustly close to one and a half year

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 30 (2006)
Issue (Month): 3 (March)
Pages: 393-413

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Handle: RePEc:eee:dyncon:v:30:y:2006:i:3:p:393-413

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  1. Glenn Rudebusch, 2000. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Econometric Society World Congress 2000 Contributed Papers 0065, Econometric Society.
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  3. Williams, John C. & Levin, Andrew T. & Wieland, Volker, 2001. "The performance of forecast-based monetary policy rules under model uncertainty," Working Paper Series 0068, European Central Bank.
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Citations

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Cited by:
  1. Dennis, Richard & Leitemo, Kai & Söderström, Ulf, 2007. "Monetary Policy in a Small Open Economy with a Preference for Robustness," CEPR Discussion Papers 6067, C.E.P.R. Discussion Papers.
  2. Loisel, O., 2006. "Bubble-free interest-rate rules," Working papers 161, Banque de France.
  3. Marcela Meirelles Aurelio, 2005. "Do we really know how inflation targeters set interest rates?," Research Working Paper RWP 05-02, Federal Reserve Bank of Kansas City.
  4. Kai Leitemo, 2006. "Open-Economy Inflation-Forecast Targeting," German Economic Review, Verein für Socialpolitik, vol. 7, pages 35-64, 02.
  5. Argov, Eyal & Binyamini, Alon & Elkayam, David & Rozenshtrom, Irit, 2007. "A Small Macroeconomic Model to Support Inflation Targeting in Israel," MPRA Paper 4784, University Library of Munich, Germany.
  6. Argov, Eyal & Elkayam, David, 2007. "An Estimated New Keynesian Model for Israel," MPRA Paper 9412, University Library of Munich, Germany.

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