Inflation targeting during asset and commodity price booms

The recent global economic crisis originated in the midst of a commodity price boom that had triggered sharp increases in inflation in many world countries. The crisis also came in the context of a rally in asset prices and large domestic imbalances in the United States. This paper uses a small open-economy dynamic stochastic general equilibrum (DSGE) model to design the correct monetary policy response to a protracted supply shock, and examines how that response would change when many become credit constrained--like in a credit crunch--and when spending of those who can still borrow becomes very sensitive to the interest rates because of overleveraging. Using a version of the model with Kalman learning, the paper also evaluates the implications of a loss of target credibility, showing how rules must be adjusted when the authorities' commitment to the inflation target has been eroded. The appropriate response to future evolutions of the price of oil, including to large downward corrections from the current level, is also evaluated. Copyright 2010, Oxford University Press.