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The Dynamic Properties of Inflation Targeting Under Uncertainty

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Author Info

  • Maria Demertzis
  • Nicola Viegi

Abstract

We study the implications of uncertainty for inflation targeting in a dynamic set-up. Using Svensson’s inflation forecast targeting model, we compare the Brainard conservative principle to a more active monetary policy rule, derived from a two-step optimisation procedure. Our analysis points to a trade-o¤ between the ability to control expectations and the introduction of greater variability in the system. We show that Brainard´s attenuation principle is optimal only in a backward looking set-up where there is no role for expectations in the determination of inflation equilibrium. On the other hand, we show that in a forward looking model, Brainard’s conservative principle may produce instability, because of its inability to control expectations. A more aggressive rule, like the one derived in the paper, can instead provide greater stability because it providesfor a better and more direct management of expectations, despite the uncertainty in the transmission parameters. In that respect, we show that there are conditions under which the bene…ts of tying down expectations, more than compensate the costs of having to overuse the instrument.

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Bibliographic Info

Paper provided by Netherlands Central Bank in its series DNB Staff Reports (discontinued) with number 113.

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Length: 30 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:dnb:staffs:113

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Related research

Keywords: Inflation Targeting; Parameter Uncertainty; Two-Step Target; Dynamic Models;

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References

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  1. Jon Faust & Lars E.O. Svensson, 1998. "Transparency and credibility: monetary policy with unobservable goals," International Finance Discussion Papers 605, Board of Governors of the Federal Reserve System (U.S.).
  2. Martin Ellison & Natacha Valla, 2000. "Learning, Uncertainty And Central Bank Activism In An Economy With Strategic Interactions," Computing in Economics and Finance 2000 183, Society for Computational Economics.
  3. Volker Wieland, 1999. "Monetary policy, parameter uncertainty and optimal learning," Finance and Economics Discussion Series 1999-48, Board of Governors of the Federal Reserve System (U.S.).
  4. Michael Woodford, 2001. "The Taylor Rule and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 91(2), pages 232-237, May.
  5. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  6. Ben S. Bernanke & Frederic S. Mishkin, 1997. "Inflation Targeting: A New Framework for Monetary Policy?," Journal of Economic Perspectives, American Economic Association, vol. 11(2), pages 97-116, Spring.
  7. repec:cup:macdyn:v:6:y:2002:i:1:p:111-44 is not listed on IDEAS
  8. Ulf Söderström, 2000. "Monetary policy with uncertain parameters," Working Paper Series 13, European Central Bank.
  9. Craine, Roger, 1979. "Optimal monetary policy with uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 1(1), pages 59-83, February.
  10. Andrew T. Levin & Fabio M. Natalucci & Jeremy M. Piger, 2004. "The macroeconomic effects of inflation targeting," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 51-80.
  11. M. Demertzis & N. Viegi, 2004. "Aiming for the Bull's Eye: Inflation Targeting under Uncertainty," DNB Staff Reports (discontinued) 88, Netherlands Central Bank.
  12. Giannoni, Marc P., 2002. "Does Model Uncertainty Justify Caution? Robust Optimal Monetary Policy In A Forward-Looking Model," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 111-144, February.
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Cited by:
  1. Frederic S. Miskin & Klaus Schmidt-Hebbel, 2007. "Monetary Policy under Inflation Targeting: An Introduction," Central Banking, Analysis, and Economic Policies Book Series, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 1, pages 001-022 Central Bank of Chile.

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