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Inflation Targeting under Imperfect Knowledge

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Author Info
Orphanides, Athanasios
Williams, John C

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Abstract

A central tenet of inflation targeting is that establishing and maintaining well-anchored inflation expectations are essential. In this paper, we reexamine the role of key elements of the inflation targeting framework towards this end, in the context of an economy where economic agents have an imperfect understanding of the macroeconomic landscape within which the public forms expectations and policymakers must formulate and implement monetary policy. Using an estimated model of the U.S. economy, we show that monetary policy rules that would perform well under the assumption of rational expectations can perform very poorly when we introduce imperfect knowledge. We then examine the performance of an easily implemented policy rule that incorporates three key characteristics of inflation targeting: transparency, commitment to maintaining price stability, and close monitoring of inflation expectations, and find that all three play an important role in assuring its success. Our analysis suggests that simple difference rules in the spirit of Knut Wicksell excel at tethering inflation expectations to the central bank’s goal and in so doing achieve superior stabilization of inflation and economic activity in an environment of imperfect knowledge.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5664.

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Date of creation: May 2006
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Handle: RePEc:cpr:ceprdp:5664

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Related research
Keywords: bond prices learning monetary policy rules natural rate of interest natural rate of unemployment rational expectations uncertainty

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Find related papers by JEL classification:
D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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Full references

Cited by:
(explanations, 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.)

  1. Roc Armenter & Martin Bodenstein, 2006. "Of nutters and doves," International Finance Discussion Papers 885, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  2. Athanasios Orphanides & John C. Williams, 2007. "Robust monetary policy with imperfect knowledge," Working Paper Series 2007-08, Federal Reserve Bank of San Francisco. [Downloadable!]
    Other versions:
  3. Nelson, Edward, 2007. "The Great Inflation and Early Disinflation in Japan and Germany," CEPR Discussion Papers 6156, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  4. Richard Dennis & Federico Ravenna, 2007. "Learning and optimal monetary policy," Working Paper Series 2007-19, Federal Reserve Bank of San Francisco. [Downloadable!]
    Other versions:
  5. Athanasios Orphanides & John C. Williams, 2005. "Monetary policy with imperfect knowledge," Finance and Economics Discussion Series 2005-51, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
    Other versions:
  6. Athanasios Orphanides & John C. Williams, 2008. "Learning, expectations formation and the pitfalls of optimal control monetary policy," Working Paper Series 2008-05, Federal Reserve Bank of San Francisco. [Downloadable!]
    Other versions:
  7. Janet L. Yellen, 2006. "Enhancing Fed credibility," Speech, Federal Reserve Bank of San Francisco, issue Mar. 13. [Downloadable!]
    Other versions:
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