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Targets and Inflation Dynamics

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  • Sergio A. L. Alves
  • Waldyr D. Areosa

Abstract

Brazil has experienced crucial changes in its inflation process since the adoption of inflation targeting in mid 1999. This article addresses changes in the analytical framework employed to track the inflation dynamics, specifically the relevance of an explicit target for inflation. A New-Keynesian Phillips curve (NKPC) is derived incorporating indexation not only to past inflation but also to inflation targets, generalizing the Woodford (2003) hybrid curve. In our modeling, firms that do not optimally set their prices in a given period adjust them only by indexing their previous prices to a weighted average of the inflation target and lagged inflation. In such a framework, the impact of inflation targets on agents' decisions regarding the supply side can be analytically measured by the parameter associated to the inflation target. It is shown that inflation target affects the welfare-based monetary policy objective function by penalizing deviations of actual inflation from target instead of from zero. This result establishes the micro foundation basis for ad-hoc loss functions as indicated in traditional literature. Therefore, the inflation target also affects the optimal target criterion. We also present a microfounded specification to model inflation expectations, and conclude that when firms attribute a high weight to the government's inflation target when setting their own prices, exchange rate and demand shocks are unable to alter significantly inflation expectations. Such a result gives some light to empirical ad hoc assessment conducted in traditional literature. Our empirical evidence shows that even after major shocks, the target ability of anchoring inflation has been restored. Although not formally tested, such a fact followed the monetary authorities' firm commitment to meet the inflation targets, reinforced by the government's necessary support through a consistent fiscal policy.

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File URL: http://www.bcb.gov.br/pec/wps/ingl/wps100.pdf
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Bibliographic Info

Paper provided by Central Bank of Brazil, Research Department in its series Working Papers Series with number 100.

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Date of creation: Oct 2005
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Handle: RePEc:bcb:wpaper:100

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Web page: http://www.bcb.gov.br/?english

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  1. Lawrence J. Christiano & Terry J. Fitzgerald, 1999. "The Band pass filter," Working Paper 9906, Federal Reserve Bank of Cleveland.
    • Lawrence J. Christiano & Terry J. Fitzgerald, 2003. "The Band Pass Filter," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(2), pages 435-465, 05.
  2. Fabio Araujo & Marta Baltar Moreira Areosa & José Alvaro Rodrigues Neto, 2003. "r-filters: a Hodrick-Prescott Filter Generalization," Working Papers Series 69, Central Bank of Brazil, Research Department.
  3. Laurence M. Ball & Niamh Sheridan, 2004. "Does Inflation Targeting Matter?," NBER Chapters, in: The Inflation-Targeting Debate, pages 249-282 National Bureau of Economic Research, Inc.
  4. Norman Loayza & Raimundo Soto, 2002. "Inflation Targeting: An Overview," Central Banking, Analysis, and Economic Policies Book Series, in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.), Inflation Targeting: Desing, Performance, Challenges, edition 1, volume 5, chapter 1, pages 001-022 Central Bank of Chile.
  5. Martin Cerisola & Gaston Gelos, 2005. "What Drives Inflation Expectations in Brazil? An Empirical Analysis," IMF Working Papers 05/109, International Monetary Fund.
  6. Frederic S. Mishkin & Klaus Schmidt-Hebbel, 2001. "One Decade of Inflation Targeting in the World: What Do We Know and What Do We Need to Know?," NBER Working Papers 8397, National Bureau of Economic Research, Inc.
  7. Marc Giannoni & Michael Woodford, 2004. "Optimal Inflation-Targeting Rules," NBER Chapters, in: The Inflation-Targeting Debate, pages 93-172 National Bureau of Economic Research, Inc.
  8. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.
  9. Fabia A de Carvalho & Mauricio S. Bugarin, 2006. "Inflation Expectations in Latin America," JOURNAL OF LACEA ECONOMIA, LACEA - LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.
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