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Monetary policy and real stabilization

  • Lars E.O Svensson

Monetary policy can achieve average inflation equal to a given inflation target and, at best, a good compromise between inflation variability and output-gap variability. The complex transmission mechanism, varying lags and strength of the effects through different channels, unpredictable shocks and inherent uncertainty prevent any fine-tuning. Monetary policy cannot completely stabilize either inflation or the output gap. Increased credibility in the form of inflation expectations anchored on the inflation target will reduce the variability of inflation and the output gap. Central banks can improve transparency and accountability by specifying not only an inflation target but also the dislike of output-gap variability relative to inflation variability. This will better focus the work inside the bank, allow more precise external monitoring and evaluation of monetary policy, and allow more precise scrutiny and debate about the monetary-policy objectives. Central banks can best achieve both the long-run inflation target and the best compromise between inflation and output-gap stability by engaging in “forecast targeting,” where at each major monetary-policy decision, the bank selects the feasible combination of inflation and output-gap projections that minimize the loss function and the corresponding instrument-rate plan and sets the instrument-rate accordingly. Announcing and motivating these forecasts maximize the impact on private-sector expectations and the economy and make the implementation of policy most effective. This allows the most effective external monitoring and evaluation of the policy, and thereby creates the strongest incentives for the bank to conduct policy according to the announced objectives. It also allows precise debate about the monetary-policy objectives. Forecast targeting implies that the instrument responds to all information that significantly affects the projections of inflation and the output gap. Therefore it cannot be expressed in term

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Article provided by Federal Reserve Bank of Kansas City in its journal Proceedings - Economic Policy Symposium - Jackson Hole.

Volume (Year): (2002)
Issue (Month): ()
Pages: 261-312

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Handle: RePEc:fip:fedkpr:y:2002:p:261-312
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