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Inflation Targeting and Traget Instability

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  • Robert J. Tetlow

    (Board of Governors of the Federal Reserve System)

Abstract

Monetary policy is modeled as being governed by a known rule, except for a time-varying target rate of inflation. The variable target can be thought of either as standing in for discretionary deviations from the rule or as the outcome of a policymaking committee that is unable to arrive at a consensus. Stochastic simulations of FRB/US, the Board of Governors’ large rational-expectations model of the U.S. economy, are used to examine the benefits of reducing the variability in the target rate of inflation. We find that putting credible boundaries on target variability introduces an important nonlinearity in expectations. The effect of this is to improve policy performance by focusing agents’ expectations on policy objectives. But improvements are limited; it does not generally pay to reduce target variability to zero. More important, this nonlinearity in expectations allows for policy to be conducted, at the margin, with greater attention to output stabilization than would otherwise be the case. The results provide insights as to why inflation-targeting countries use bands and why the bands they use are narrower than studies suggest they should be. A side benefit of the paper is the demonstration of a numerical technique that approximates to arbitrary precision a nonlinear process with a linear method, thereby greatly speeding and making more robust the computation of simulation results.

Suggested Citation

  • Robert J. Tetlow, 2008. "Inflation Targeting and Traget Instability," International Journal of Central Banking, International Journal of Central Banking, vol. 4(4), pages 151-192, December.
  • Handle: RePEc:ijc:ijcjou:y:2008:q:4:a:5
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    References listed on IDEAS

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    Cited by:

    1. Andrew Levin & Volker Wieland & John C. Williams, 2003. "The Performance of Forecast-Based Monetary Policy Rules Under Model Uncertainty," American Economic Review, American Economic Association, vol. 93(3), pages 622-645, June.
    2. Ruge-Murcia, Francisco J, 2003. " Inflation Targeting under Asymmetric Preferences," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(5), pages 763-785, October.
    3. Oleg Korenok & Stanislav Radchenko, 2005. "Expectations Anchoring in Inflation Targeting Regimes," Working Papers 0503, VCU School of Business, Department of Economics.
    4. William C. Whitesell, 2005. "An inflation goal with multiple reference measures," Finance and Economics Discussion Series 2005-62, Board of Governors of the Federal Reserve System (U.S.).
    5. Felipe F. Schwartzman, 2005. "Inflation Target Zones As A Commitment Mechanism," Anais do XXXIII Encontro Nacional de Economia [Proceedings of the 33th Brazilian Economics Meeting] 038, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].

    More about this item

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling

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