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What horizon for targeting inflation?

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  • Q. Akram

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Abstract

We investigate optimal horizons for targeting inflation in response to different shocks and their properties under alternative preferences of an inflation-targeting central bank. Our analysis is based on a well specified macroeconometric model of Norway, but we examine how alternative specifications of its key equations would affect our results. We find that the optimal horizon is highly shock-specific, precluding general conclusions for demand and supply shocks. An extension of the horizon with concern for output and/or interest rate fluctuations beyond some shock-specific level proves counterproductive. The size of a given shock does not affect the horizon unless the central bank cares about interest rate volatility, while its sign does not matter unless the model is non-linear. The optimal horizon in response to a combination of shocks cannot be derived from those for each of the shocks, as different shocks may amplify or modify the effects of each other. In this case, however, sources of shocks as well as their sizes and signs become relevant, leading to complex dynamics of inflation and output. Successful inflation targeting in such cases may require a complex interest rate response. The optimal horizon generally increases with the degree of persistence in a shock and decreases with the strength of stabilisation mechanisms in the model.

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File URL: http://hdl.handle.net/10.1007/s00181-009-0330-6
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Bibliographic Info

Article provided by Springer in its journal Empirical Economics.

Volume (Year): 39 (2010)
Issue (Month): 3 (December)
Pages: 675-702

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Handle: RePEc:spr:empeco:v:39:y:2010:i:3:p:675-702

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Related research

Keywords: Monetary policy; Inflation targeting; Horizon; C53; E31; E52;

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  1. Eric M. Leeper & Tao Zha, 2002. "Modest Policy Interventions," NBER Working Papers 9192, National Bureau of Economic Research, Inc.
  2. Gunnar Bardsen & Eilev S. Jansen & Ragnar Nymoen, 2003. "Econometric inflation targeting," Econometrics Journal, Royal Economic Society, vol. 6(2), pages 430-461, December.
  3. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  4. Scott Roger & Mark R. Stone, 2005. "On Target? the International Experience with Achieving Inflation Targets," IMF Working Papers 05/163, International Monetary Fund.
  5. Nicoletta Batini & Edward Nelson, 2000. "Optimal horizons for inflation targeting," Bank of England working papers 119, Bank of England.
  6. Bennett T. McCallum & Edward Nelson, 2000. "Nominal Income Targeting in an Open-Economy Optimizing Model," NBER Working Papers 6675, National Bureau of Economic Research, Inc.
  7. Milton Friedman, 1961. "The Lag in Effect of Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 69, pages 447.
  8. Brian Sack & Volker Wieland, 1999. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Finance and Economics Discussion Series 1999-39, Board of Governors of the Federal Reserve System (U.S.).
  9. Neil R. Ericsson & John S. Irons, 1995. "The Lucas critique in practice: theory without measurement," International Finance Discussion Papers 506, Board of Governors of the Federal Reserve System (U.S.).
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