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An Explicit Inflation Target As A Commitment Device

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  • Jan Libich

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Abstract

This paper shows an avenue through which a numerical inflation target ensures low inflation and high credibility: one that is independent of the usual Walsh incentive contract. Our novel game theoretic framework - a generalization of alternating move games - formalizes the fact that since the target is explicit/legislated, it cannot be frequently reconsidered. The "explicitness" therefore serves as a commitment device. There are two key results. First, it is shown that if the inflation target is sufficiently rigid (explicit) relative to the public's wages, low inflation is time consistent and hence credible even if the policymaker's output target is above potential. Second, it is found that the central banker's optimal explicitness level is decreasing in the degree of her patience/independence (due to their substitutability in achieving credibility). Our analysis therefore offers an explanation for the "inflation and credibility convergence" over the past two decades as well as the fact that inflation targets were legislated primarily by countries that had lacked central bank independence like New Zealand, Canada and the UK rather than the US, Germany, or Switzerland. We show that there exists fair empirical support for all the predictions of our analysis.

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Bibliographic Info

Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2006-22.

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Length: 42 pages
Date of creation: Sep 2006
Date of revision:
Handle: RePEc:een:camaaa:2006-22

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References

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Citations

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Cited by:
  1. Oleg KITOV & Ivan KITOV, 2012. "Inflation And Unemployment In Switzerland: From 1970 To 2050," Journal of Applied Economic Sciences, Spiru Haret University, Faculty of Financial Management and Accounting Craiova, Spiru Haret University, Faculty of Financial Management and Accounting Craiova, vol. 7(2(20)/ Su), pages 141-156.
  2. Hughes Hallett, Andrew & Libich, Jan & Stehlík, Petr, 2007. "Monetary and Fiscal Policy Interaction with Various Degrees and Types of Commitment," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6586, C.E.P.R. Discussion Papers.
  3. Jan Libich & Petr Stehlik, 2009. "Endogenous Monetary Commitment," CAMA Working Papers, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University 2009-01, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  4. Jan Libich & Petr Stehlik, 2008. "Fiscal Rigidity In A Monetary Union: The Calvo Timing And Beyond," CAMA Working Papers, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University 2008-22, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  5. Jan Libich, 2009. "A Note on the Anchoring Effect of Explicit Inflation Targets," CAMA Working Papers, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University 2009-21, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  6. Andrew Hughes Hallett & Jan Libich, 2007. "Fiscal-monetary Interactions: The Effect of Fiscal Restraint and Public Monitoring on Central Bank Credibility," Open Economies Review, Springer, Springer, vol. 18(5), pages 559-576, November.

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