Inflation Targeting, Credibility and Confidence Crises

We study the interplay between the central bank transparency, its credibility, and the inflation target level. Based on a model developed in the spirit of the global games literature, we argue that whenever a weak central bank adopts a high degree of transparency and a low target level, a bad and self confirmed type of equilibrium may arise. In this case, an over-the-target inflation becomes more likely. The central bank is considered weak when favorable state of nature is required for the target to be achieved. On the other hand, if a weak central bank opts for less ambitious goals, namely lower degree of transparency and higher target level, it may avoid confidence crises and ensure a unique equilibrium for the expected inflation. Moreover, even after ruling out the possibility of confidence crises, less ambitious goals may be desirable in order to attain higher credibility and hence a better coordination of expectations. Conversely, a low target level and a high central bank transparency are desirable whenever the economy has strong fundamentals and the target can be fulfilled in many states of nature.