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Targeting Inflation by Forecast Feedback Rules in Small Open Economies

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Author Info
Kai Leitemo

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Abstract

We argue that inflation-targeting strategy in practice can be approximated with the interest rate responding to the unchanged-interest-rate forecast of inflation. We develop a method to derive unchanged-interest-rate forecasts in forward-looking models and evaluate the performance of the policy rule in an optimizing New Keynesian model due to Monacelli (2003) estimated on UK data. We find that the policy rule is less prone to generate a determinate rational expectations equilibrium if based on an unchanged interest rate compared to the rule-consistent forecast. The rule approximates the optimal commitment policy if the central bank attaches sufficient weight to inflation as opposed to output gap stabilization. The optimal forecast horizon is robustly close to one and a half year

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2004 with number 18.

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Date of creation: 11 Aug 2004
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Handle: RePEc:sce:scecf4:18

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Related research
Keywords: Inflation Targeting; monetary policy; feedback rules; open economy;

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Find related papers by JEL classification:
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation
E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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References listed on IDEAS
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. Glenn D. Rudebusch, 2001. "Term structure evidence on interest rate smoothing and monetary policy inertia," Working Papers in Applied Economic Theory 2001-02, Federal Reserve Bank of San Francisco. [Downloadable!]
    Other versions:
  2. Kai Leitemo, 2006. "Open-Economy Inflation-Forecast Targeting," German Economic Review, Blackwell Publishing, vol. 7, pages 35-64, 02. [Downloadable!] (restricted)
  3. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April. [Downloadable!] (restricted)
    Other versions:
  4. Klein, Paul, 2000. "Using the generalized Schur form to solve a multivariate linear rational expectations model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(10), pages 1405-1423, September. [Downloadable!] (restricted)
  5. Andrew Levin & Volker Wieland & John C. Williams, 2003. "The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty," CFS Working Paper Series 2003/06, Center for Financial Studies. [Downloadable!]
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  6. Lars E. O. Svensson, 1997. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," NBER Working Papers 5797, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Nicoletta Batini & Andrew Haldane, 1999. "Forward-Looking Rules for Monetary Policy," NBER Chapters, in: Monetary Policy Rules, pages 157-202 National Bureau of Economic Research, Inc. [Downloadable!]
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  8. Adolfson, Malin, 2001. "Monetary Policy with Incomplete Exchange Rate Pass-Through," Working Paper Series in Economics and Finance 476, Stockholm School of Economics. [Downloadable!]
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  9. Svensson, Lars E O & Woodford, Michael, 2004. "Implementing Optimal Policy Through Inflation-Forecast Targeting," CEPR Discussion Papers 4229, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  10. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," NBER Working Papers 8403, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  11. Glenn D. Rudebusch, 2002. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Economic Journal, Royal Economic Society, vol. 112(479), pages 402-432, April. [Downloadable!] (restricted)
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  12. Michael Woodford, 2001. "The Taylor Rule and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 91(2), pages 232-237, May. [Downloadable!] (restricted)
  13. 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. [Downloadable!] (restricted)
  14. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September. [Downloadable!] (restricted)
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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. Dennis, Richard & Leitemo, Kai & Söderström, Ulf, 2007. "Monetary Policy in a Small Open Economy with a Preference for Robustness," CEPR Discussion Papers 6067, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  2. Argov, Eyal & Elkayam, David, 2007. "An Estimated New Keynesian Model for Israel," MPRA Paper 9412, University Library of Munich, Germany. [Downloadable!]
  3. Loisel, O., 2006. "Bubble-free interest-rate rules," Documents de Travail 161, Banque de France. [Downloadable!]
  4. Marcela Meirelles Aurelio, 2005. "Do we really know how inflation targeters set interest rates?," Research Working Paper RWP 05-02, Federal Reserve Bank of Kansas City. [Downloadable!]
  5. Argov, Eyal & Binyamini, Alon & Elkayam, David & Rozenshtrom, Irit, 2007. "A Small Macroeconomic Model to Support Inflation Targeting in Israel," MPRA Paper 4784, University Library of Munich, Germany. [Downloadable!]
  6. Anatoliy Belaygorod & Michael J. Dueker, 2007. "The price puzzle and indeterminacy in an estimated DSGE model," Working Papers 2006-025, Federal Reserve Bank of St. Louis. [Downloadable!]
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