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Inflation Targeting, Credibility and Confidence Crises

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  • Araújo, Aloísio Pessoa de
  • Santos, Rafael Chaves

Abstract

We study the interplay between the central bank transparency, its credibility, and the inflation target level. Based on a model developed in the spirit of the global games literature, we argue that whenever a weak central bank adopts a high degree of transparency and a low target level, a bad and self confirmed type of equilibrium may arise. In this case, an over-the-target inflation becomes more likely. The central bank is considered weak when favorable state of nature is required for the target to be achieved. On the other hand, if a weak central bank opts for less ambitious goals, namely lower degree of transparency and higher target level, it may avoid confidence crises and ensure a unique equilibrium for the expected inflation. Moreover, even after ruling out the possibility of confidence crises, less ambitious goals may be desirable in order to attain higher credibility and hence a better coordination of expectations. Conversely, a low target level and a high central bank transparency are desirable whenever the economy has strong fundamentals and the target can be fulfilled in many states of nature.

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Paper provided by FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil) in its series Economics Working Papers (Ensaios Economicos da EPGE) with number 653.

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Date of creation: 01 Sep 2007
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Handle: RePEc:fgv:epgewp:653

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Cited by:
  1. Solange Gouvea, 2007. "Price Rigidity in Brazil: Evidence from CPI Micro Data," Working Papers Series, Central Bank of Brazil, Research Department 143, Central Bank of Brazil, Research Department.
  2. Ricardo Schechtman, 2007. "Joint Validation of Credit Rating PDs under Default Correlation," Working Papers Series, Central Bank of Brazil, Research Department 149, Central Bank of Brazil, Research Department.

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