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An explicit inflation target as a commitment device

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Author Info
Libich, Jan

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Abstract

This paper shows an avenue through which a numerical long-run inflation target ensures low inflation and high credibility; one that is independent of the usual Walsh incentive contract. Our novel game theoretic framework - a generalization of alternating move games - formalizes the fact that since the target is explicit (legislated), it cannot be frequently reconsidered. This [`]explicitness' therefore serves as a commitment device. There are two key results. First, it is shown that if the inflation target is sufficiently rigid/explicit relative to the public's wages, low inflation is time consistent and hence credible even if the policymaker's output target is above potential. Second, it is found that the central banker's optimal explicitness level is decreasing in the degree of his patience/independence (due to their substitutability in achieving credibility). Our analysis therefore offers an explanation for the [`]inflation and credibility convergence' over the past two decades as well as the fact that inflation targets were legislated primarily by countries that had lacked central bank independence like New Zealand, Canada, and the UK rather than the US, Germany, or Switzerland. We show that there exists fair empirical support for all the predictions of our analysis.

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Article provided by Elsevier in its journal Journal of Macroeconomics.

Volume (Year): 30 (2008)
Issue (Month): 1 (March)
Pages: 43-68
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Handle: RePEc:eee:jmacro:v:30:y:2008:i:1:p:43-68

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Web page: http://www.elsevier.com/locate/inca/622617

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  1. Andrew Hughes Hallett & Jan Libich, 2007. "Fiscal-monetary Interactions: The Effect of Fiscal Restraint and Public Monitoring on Central Bank Credibility," Open Economies Review, Springer, vol. 18(5), pages 559-576, November. [Downloadable!] (restricted)
  2. Jan Libich & Petr Stehlik, 2008. "Fiscal Rigidity In A Monetary Union: The Calvo Timing And Beyond," CAMA Working Papers 2008-22, Australian National University, Centre for Applied Macroeconomic Analysis. [Downloadable!]
  3. Jan Libich & Andrew Hughes Hallett & Petr Stehlik, 2007. "Monetary And Fiscal Policy Interaction With Various Degrees And Types Of Commitment," CAMA Working Papers 2007-21, Australian National University, Centre for Applied Macroeconomic Analysis. [Downloadable!]
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