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Inflation Tolerance Bands and Private Sector Beliefs

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  • Fabio Milani

Abstract

This paper estimates a New Keynesian model with a nonlinearity in the monetary policy rule to capture the practice of inflation targeting with target zones or tolerance bands. Private-sector agents form subjective expectations, update their beliefs over time using a perceived model of the economy, and are subject to shifts in sentiment. The model is estimated using data on realized macroeconomic variables and survey data on expectations for four inflation-targeting economies: Australia, Canada, New Zealand, and Sweden. The results show that central banks do not treat target bands as zones of inaction. Their policy reactions when inflation falls within the band are comparable to or even exceed the reactions when inflation moves outside the band, and they always satisfy the Taylor principle. Private-sector expectations respond similarly to structural and sentiment shocks regardless of the inflation regime. In all cases, the data favor the simpler specification in which agents form expectations based on linear perceived laws of motion, without accounting for the nonlinearity induced by monetary policy.

Suggested Citation

  • Fabio Milani, 2025. "Inflation Tolerance Bands and Private Sector Beliefs," CESifo Working Paper Series 11910, CESifo.
  • Handle: RePEc:ces:ceswps:_11910
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    File URL: https://www.ifo.de/DocDL/cesifo1_wp11910.pdf
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    References listed on IDEAS

    as
    1. Christopher J. Erceg, 2002. "The Choice of an Inflation Target Range in a Small Open Economy," American Economic Review, American Economic Association, vol. 92(2), pages 85-89, May.
    2. Ehrmann, Michael, 2021. "Point targets, tolerance bands or target ranges? Inflation target types and the anchoring of inflation expectations," Journal of International Economics, Elsevier, vol. 132(C).
    3. Ilabaca, Francisco & Milani, Fabio, 2021. "Heterogeneous expectations, indeterminacy, and postwar US business cycles," Journal of Macroeconomics, Elsevier, vol. 68(C).
    4. Francesco Bianchi & Giovanni Nicolò, 2021. "A generalized approach to indeterminacy in linear rational expectations models," Quantitative Economics, Econometric Society, vol. 12(3), pages 843-868, July.
    5. Vitor Gaspar & Frank Smets & David Vestin, 2006. "Adaptive Learning, Persistence, and Optimal Monetary Policy," Journal of the European Economic Association, MIT Press, vol. 4(2-3), pages 376-385, 04-05.
    6. George W. Evans, 2001. "Expectations in Macroeconomics. Adaptive versus Eductive Learning," Revue Économique, Programme National Persée, vol. 52(3), pages 573-582.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    inflation targeting; tolerance bands; target ranges; survey expectations; learning; nonlinear monetary policy rules;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E70 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - General

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