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Open-Economy Inflation-Forecast Targeting

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  • Kai Leitemo

Abstract

We study simple inflation-forecast targeting in an open-economy setting. Simple inflation-forecast targeting implies setting an interest rate which, if kept unchanged throughout the forecast-targeting horizon, produces a conditional inflation forecast equal to the inflation target at the end of the horizon. We find that the optimal forecast-targeting horizon is relatively short (one year). A longer horizon does not consistently contribute to improved output stability, indeed it increases exchange rate variability and traded sector variability. The targeting procedure is substantially inferior to the optimal pre-commitment policy. Moreover, the targeting procedure does not necessarily determine the rational-expectations equilibrium and is subject to time inconsistency. Copyright Verein für Socialpolitik and Blackwell Publishing Ltd. 2006.

Suggested Citation

  • Kai Leitemo, 2006. "Open-Economy Inflation-Forecast Targeting," German Economic Review, Verein für Socialpolitik, vol. 7, pages 35-64, February.
  • Handle: RePEc:bla:germec:v:7:y:2006:i::p:35-64
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    References listed on IDEAS

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    1. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, pages 553-578.
    2. Fisher, P G, et al, 1990. "Econometric Evaluation of the Exchange Rate in Models of the UK Economy," Economic Journal, Royal Economic Society, vol. 100(403), pages 1230-1244, December.
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    5. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, pages 1661-1707.
    6. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Working Papers in Applied Economic Theory 98-03, Federal Reserve Bank of San Francisco.
    7. Bullard, James & Mitra, Kaushik, 2002. "Learning about monetary policy rules," Journal of Monetary Economics, Elsevier, pages 1105-1129.
    8. Leitemo, Kai, 2006. "Targeting inflation by forecast feedback rules in small open economies," Journal of Economic Dynamics and Control, Elsevier, pages 393-413.
    9. Glenn Rudebusch & Lars E.O. Svensson, 1999. "Policy Rules for Inflation Targeting," NBER Chapters,in: Monetary Policy Rules, pages 203-262 National Bureau of Economic Research, Inc.
    10. Bullard, James & Mitra, Kaushik, 2002. "Learning about monetary policy rules," Journal of Monetary Economics, Elsevier, pages 1105-1129.
    11. Samaniego, Roberto M., 2008. "Can technical change exacerbate the effects of labor market sclerosis," Journal of Economic Dynamics and Control, Elsevier, pages 497-528.
    12. Roberts, John M, 1995. "New Keynesian Economics and the Phillips Curve," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 975-984, November.
    13. Kai Leitemo & Ulf Soderstrom, 2001. "Simple monetary policy rules and exchange rate uncertainty," Proceedings, Federal Reserve Bank of San Francisco.
    14. 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.
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    17. Bennett T. Mccallum, 2003. "Is The Fiscal Theory of the Price Level Learnable?," Scottish Journal of Political Economy, Scottish Economic Society, pages 634-649.
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    22. Leitemo, Kai, 2003. " Targeting Inflation by Constant-Interest-Rate Forecasts," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(4), pages 609-626, August.
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    Citations

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    Cited by:

    1. Marcelo Sanchez, 2008. "The link between interest rates and exchange rates: do contractionary depreciations make a difference?," International Economic Journal, Taylor & Francis Journals, pages 43-61.
    2. Sánchez, Marcelo, 2005. "The link between interest rates and exchange rates: do contractionary depreciations make a difference?," Working Paper Series 548, European Central Bank.
    3. Leitemo, Kai, 2006. "Targeting inflation by forecast feedback rules in small open economies," Journal of Economic Dynamics and Control, Elsevier, pages 393-413.
    4. Franz Seitz & Karl-Heinz Tödter, 2001. "How the P* Model Rationalizes Monetary Targeting: A Comment on Svensson," German Economic Review, Verein für Socialpolitik, vol. 2(3), pages 303-308, August.
    5. Herwartz Helmut & Roestel Jan, 2009. "Monetary Independence under Floating Exchange Rates: Evidence Based on International Breakeven Inflation Rates," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, pages 1-25.
    6. Samaniego, Roberto M., 2008. "Can technical change exacerbate the effects of labor market sclerosis," Journal of Economic Dynamics and Control, Elsevier, pages 497-528.
    7. Argov, Eyal & Elkayam, David, 2007. "An Estimated New Keynesian Model for Israel," MPRA Paper 9412, University Library of Munich, Germany.
    8. Magdalena Szyszko, 2013. "The interdependences of central bank’s forecasts and inflation expectations of consumers," Bank i Kredyt, Narodowy Bank Polski, vol. 44(1), pages 33-66.
    9. 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.

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