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What horizon for targeting inflation?

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  • Q. Farooq Akram.

    (Norges Bank (Central Bank of Norway))

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://www.norges-bank.no/en/Published/Papers/Working-Papers/2007/WP-200713/
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Bibliographic Info

Paper provided by Norges Bank in its series Working Paper with number 2007/13.

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Length: 45 pages
Date of creation: 24 Jan 2008
Date of revision:
Handle: RePEc:bno:worpap:2007_13

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Keywords: Monetary policy; Inflation targeting; Horizon;

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  1. Nicoletta Batini & Edward Nelson, 2000. "Optimal horizons for inflation targeting," Bank of England working papers 119, Bank of England.
  2. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  3. Scott Roger & Mark R. Stone, 2005. "On Target? the International Experience with Achieving Inflation Targets," IMF Working Papers 05/163, International Monetary Fund.
  4. McCallum, Bennett T. & Nelson, Edward, 1998. "Nominal Income Targeting in an Open-Economy Optimizing Model," Seminar Papers 644, Stockholm University, Institute for International Economic Studies.
  5. Leeper, Eric M. & Zha, Tao, 2003. "Modest policy interventions," Journal of Monetary Economics, Elsevier, vol. 50(8), pages 1673-1700, November.
  6. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228.
  7. 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.).
  8. Gunnar Bårdsen & Eilev S. Jansen & Ragnar Nymoen, 1999. "Econometric Inflation Targeting," Working Paper Series 0502, Department of Economics, Norwegian University of Science and Technology, revised 30 Oct 2001.
  9. Milton Friedman, 1961. "The Lag in Effect of Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 69, pages 447.
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