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Inflation Targeting and Traget Instability

  • Robert J. Tetlow

    (Board of Governors of the Federal Reserve System)

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.

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Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 4 (2008)
Issue (Month): 4 (December)
Pages: 151-192

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Handle: RePEc:ijc:ijcjou:y:2008:q:4:a:5
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  1. John C. Williams, 2003. "Simple rules for monetary policy," Economic Review, Federal Reserve Bank of San Francisco, pages 1-12.
  2. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
  3. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," CEPR Discussion Papers 1908, C.E.P.R. Discussion Papers.
  4. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
  5. Summers, Lawrence, 1991. "How Should Long-Term Monetary Policy Be Determined? Panel Discussion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 625-31, August.
  6. Aksoy, Yunus & Orphanides, Athanasios & Small, David & Wieland, Volker & Wilcox, David, 2003. "A Quantitative Exploration of the Opportunistic Approach to Disinflation," CEPR Discussion Papers 4073, C.E.P.R. Discussion Papers.
  7. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
  8. Alessandro Riboni & Francisco J. Ruge-Murcia, 2008. "The Dynamic (In)Efficiency of Monetary Policy by Committee," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 1001-1032, 08.
  9. Eijffinger, Sylvester C W & Huizinga, Harry, 1999. "Should Monetary Policy be Adjusted Frequently?," CEPR Discussion Papers 2074, C.E.P.R. Discussion Papers.
  10. Glenn D. Rudebusch, 1999. "Is the Fed too timid? Monetary policy in an uncertain world," Working Papers in Applied Economic Theory 99-05, Federal Reserve Bank of San Francisco.
  11. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  12. John B. Taylor, 1994. "The inflation/output variability trade-off revisited," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, vol. 38, pages 21-24.
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