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Targeting Rules with Intrinsic Persistence and Endogenous Policy Inertia

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  • Michael S. Hanson

    ()
    (Department of Economics, Wesleyan University)

  • Pavel Kapinos

    ()
    (Department of Economics, Carleton College)

Abstract

We investigate the optimality of monetary policy targeting rules in a macroeconomic model based on explicit micro-foundations for intrinsic persistence in inflation and real output. For the corresponding social welfare loss function to be minimized by the central bank, inertia arises endogenously in both the inflation and output gap stabilization objectives. In this framework, inflation targeting closely approximates the optimal precommitment policy for empirically relevant parameter values. Alternative policy rules, such as nominal income growth targeting, “speed-limit” targeting, or price level targeting, do not performas well. Previous research has demonstrated lower social welfare losses with these alternative targeting rules; such findings are shown to be primarily a consequence of assuming the central bank minimizes a simple social loss function that is not consistent with the micro-foundations of a model with intrinsic persistence.

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Bibliographic Info

Paper provided by Wesleyan University, Department of Economics in its series Wesleyan Economics Working Papers with number 2006-019.

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Length: 35 pages
Date of creation: Jun 2006
Date of revision:
Handle: RePEc:wes:weswpa:2006-019

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Keywords: Habit formation; inflation persistence; targeting rules; time consistency; institutional design of monetary policy;

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