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Does an inflation target zone help or hinder price stability?

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  • Della Posta, Pompeo
  • Tamborini, Roberto

Abstract

A significant number of central banks pursuing price stability operate an inflation target zone (ITZ) by letting inflation float within a band. The available literature is not conclusive on whether ITZs contribute to price stability. We elaborate and simulate a novel symmetric stochastic ITZ model inspired by the literature on exchange-rate agreements. Our new finding is that the performance of ITZs depends on whether the central bank sets the boundaries with certainty. In this case, it can accommodate larger shocks and set a lower interest rate at the point of intervention, with inflation remaining within the band and close on average to the central target. However, these benefits are reversed if the bandwidth is uncertain. Our simulations also show that a wider band leads to higher mean and variance of inflation, but it is still to be preferred to a narrow one if it is recognized as better defensible.

Suggested Citation

  • Della Posta, Pompeo & Tamborini, Roberto, 2023. "Does an inflation target zone help or hinder price stability?," Economic Modelling, Elsevier, vol. 129(C).
    • Handle: RePEc:eee:ecmode:v:129:y:2023:i:c:s0264999323003449
    DOI: 10.1016/j.econmod.2023.106532
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    More about this item

    Keywords

    Inflation targeting; Target zone;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System

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