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Learning and the Welfare Implications of Changing Inflation Targets

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Kevin Moran

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Abstract

This paper computes the welfare consequences, for a representative agent, of a shift in the inflation target of monetary authorities. The welfare computations are conducted first by comparing the two steady states that the different inflation targets entail, and next by accounting for the transition from one steady-state to the next. Further, the paper allows this transition to be characterized by incomplete information, under which private agents learn about the inflation target shift using Bayesian updating. The analysis is repeated in a variety of model parameterizations, to test the robustness of the results. We find that the welfare benefits of reducing the target rate of inflation from 2% initially to 0% may at first appear to be significant. When measured by comparing steady states, these benefits are worth up to 0.5% of steady-state consumption. However, accounting for the transition towards the new, low inflation steady state significantly reduces the computed benefits, by at least one half.

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Paper provided by CIRPEE in its series Cahiers de recherche with number 0511.

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Date of creation: 2005
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Handle: RePEc:lvl:lacicr:0511

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Related research
Keywords: Inflation targeting; welfare benefits of lower inflation; new keynesian model;

Find related papers by JEL classification:
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
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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  1. Melecky, Martin & Rodrıguez Palenzuela, Diego & Soderstrom, Ulf, 2008. "Inflation Target Transparency and the Macroeconomy," MPRA Paper 10545, University Library of Munich, Germany. [Downloadable!]
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