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A Theory of Dynamic Inflation Targets

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  • Clayton, Christopher
  • Schaab, Andreas

Abstract

Should central banks’ inflation targets remain set in stone? We study a dynamic mechanism design problem between a government (principal) and a central bank (agent). The central bank has persistent private information about structural shocks. Firms learn the state from the central bank’s reports and form inflation expectations accordingly. A dynamic inflation target implements the full-information commitment allocation: the central bank is delegated the authority to adjust its own target as long as it does so one period in advance. Both the level and flexibility of the dynamic inflation target respond to persistent shocks. Target flexibility is set to correct the time consistency problem, while the target level provides the correct incentives for target adjustments. An informational divine coincidence arises: the central bank’s incentives to misreport its persistent private information to manipulate firm and government beliefs exactly offset each other under the mechanism. We apply our theory to study lower bound spells, a declining natural interest rate, and a flattening Phillips curve. We leverage our framework to study longer-horizon time consistency problems and speak to practical policy questions of inflation target design.

Suggested Citation

  • Clayton, Christopher & Schaab, Andreas, 2022. "A Theory of Dynamic Inflation Targets," TSE Working Papers 22-1389, Toulouse School of Economics (TSE).
    • Handle: RePEc:tse:wpaper:127586
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    More about this item

    Keywords

    inflation targeting; persistent private information; dynamic mechanism design; monetary policy; time consistency; dynamic inflation targets; informational divine coincidence;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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