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Gaining Credibility for Inflation Targets

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  • James Yetman

Abstract

In this paper, I consider a simple model in which agents learn about the inflation target of a central bank over time by observing the policy instrument or inflation outcomes. Measuring credibility as the distance between the perceived target and the actual target, an increase in credibility is beneficial to the central bank because it brings the policy consistent with attaining the inflation target closer to that required to attain the output target. In this model, the crucial assumptions are that (i) the central bank knows what its target is, but lacks the means to credibly communicate it to agents, and (ii) observed changes in the policy instrument do not perfectly inform agents about the objective of the central bank. Optimal monetary policy therefore entails endogenizing the learning process of agents and solving the resultant "optimal-control" problem. I show that a linear approximation of the optimal-control problem is observationally equivalent to a "conservative central banker" in the sense of Rogoff (1985), results in most of the gains that are available from pursuing a higher-order approximation for reasonable degrees of initial credibility, and may actually be preferable if agents cannot determine the exact weights with which to update their view of the target. A conservative central banker is especially beneficial if society places a high weight on output deviations from target. I then illustrate the impact of other factors on credibility formation, including choice of monetary policy instrument, transparency, and publishing forecasts.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 01-11.

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Length: 42 pages
Date of creation: 2001
Date of revision:
Handle: RePEc:bca:bocawp:01-11

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Keywords: Credibility; Inflation targets;

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Cited by:
  1. Leon, Jorge & Laverde, Bernal & Duran, Rodolfo, 2002. "Pass Through del Tipo de Cambio en los Precios de Bienes Transables y No Transables en Costa Rica
    [Exchange Rate Pass Through into the Prices of Tradable and Non Tradable Goods in Costa Rica]
    ," MPRA Paper 44527, University Library of Munich, Germany, revised 2002.
  2. Paul Jenkins & Brian O'Reilly, 2001. "Monetary Policy and the Economic Well-being of Canadians," The Review of Economic Performance and Social Progress, in: Andrew Sharpe, Executive Director & France St-Hilaire, Vice-President , Research & Keith Banting, Di (ed.), The Review of Economic Performance and Social Progress 2001: The Longest Decade: Canada in the 1990s, volume 1 Centre for the Study of Living Standards & The Institutute for Research on Public Policy.
  3. Gabriel Srour, 2001. "Why Do Central Banks Smooth Interest Rates?," Working Papers 01-17, Bank of Canada.

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