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Inflation Targeting - a Framework for Communication

  • Maria Demertzis
  • Nicola Viegi

More than a monetary policy strategy, we interpret inflation targeting as a framework for communication. We model monetary policy as an information game between the Bank and private agents. Our analysis shows how the provision of an explicit numerical inflation objective overcomes potential information imperfections by providing a focal point for agents who form expectations. Furthermore, the combination of the target and the tolerance bands around it communicated, provide a very clear framework with which to evaluate monetary policy outcomes. A successful Central Bank then builds up credibility and a credible Central Bank is in a better position to be successful in subsequent periods. We show how (and when) inflation targeting exploits this self-reinforcing loop to help the Central Bank endure large and long-lasting shocks. Last, we show that a trade-off emerges when choosing the band-width: too narrow bands provide a focal point but reduce the likelihood of inflation being successful'. Too wide bands on the other hand, lead easier to success but at the risk of failing to provide a clear focal point. We thus derive the optimal band-width for different scenarios.

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Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 149.

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Date of creation: Oct 2007
Handle: RePEc:dnb:dnbwpp:149
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  1. Robert G. King & Alexander L. Wolman, 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," International Finance Discussion Papers 802, Board of Governors of the Federal Reserve System (U.S.).
  2. Bomfim, Antulio N & Rudebusch, Glenn D, 2000. "Opportunistic and Deliberate Disinflation under Imperfect Credibility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 707-21, November.
  3. Marvin Goodfriend, 2007. "How the World Achieved Consensus on Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 21(4), pages 47-68, Fall.
  4. Frederic S. Miskin & Klaus Schmidt-Hebbel, 2007. "Does Inflation Targeting Make a Difference?," Central Banking, Analysis, and Economic Policies Book Series, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 9, pages 291-372 Central Bank of Chile.
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  7. M. Demertzis & A. Hughes Hallet, 2002. "Central Bank Transparency in Theory and Practice," WO Research Memoranda (discontinued) 704, Netherlands Central Bank, Research Department.
  8. Orphanides, Athanasios & Williams, John C., 2004. "The decline of activist stabilization policy: Natural rate misperceptions, learning, and expectations," CFS Working Paper Series 2004/24, Center for Financial Studies (CFS).
  9. Maria Demertzis & Nicola Viegi, 2004. "Inflation Targets as Focal Points," DNB Working Papers 017, Netherlands Central Bank, Research Department.
  10. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  11. Blackburn, Keith & Christensen, Michael, 1989. "Monetary Policy and Policy Credibility: Theories and Evidence," Journal of Economic Literature, American Economic Association, vol. 27(1), pages 1-45, March.
  12. Giuseppe Moscarini, 2007. "Competence Implies Credibility," American Economic Review, American Economic Association, vol. 97(1), pages 37-63, March.
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  14. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  15. Jon Faust & Dale W. Henderson, 2004. "Is inflation targeting best-practice monetary policy?," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 117-144.
  16. Johnson, David R., 2002. "The effect of inflation targeting on the behavior of expected inflation: evidence from an 11 country panel," Journal of Monetary Economics, Elsevier, vol. 49(8), pages 1521-1538, November.
  17. Frederic S. Mishkin & Niklas J. Westelius, 2008. "Inflation Band Targeting and Optimal Inflation Contracts," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(4), pages 557-582, 06.
  18. King, Mervyn, 1997. "Changes in UK monetary policy: Rules and discretion in practice," Journal of Monetary Economics, Elsevier, vol. 39(1), pages 81-97, June.
  19. Canzoneri, Matthew B, 1985. "Monetary Policy Games and the Role of Private Information," American Economic Review, American Economic Association, vol. 75(5), pages 1056-70, December.
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  21. Benati, Luca, 2008. "Investigating inflation persistence across monetary regimes," Working Paper Series 0851, European Central Bank.
  22. Robert G. King & Alexander L. Wolman, 2004. "Monetary Discretion, Pricing Complementarity, and Dynamic Multiple Equilibria," The Quarterly Journal of Economics, Oxford University Press, vol. 119(4), pages 1513-1553.
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