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Inflexibility Of Inflation Targeting Revisited: Modeling The "Anchoring"Effect

  • Jan Libich

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Opponents of inflation targeting have argued that a commitment to a numerical inflation target reduces policy's stabilization flexibility - increasing output volatility under supply shocks. Using a novel game theoretic approach our paper demonstrates that this claim may fail to account for the "anchoring" effect of explicit targets on expectations and wages. Under a credible long-term inflation target and costly acquiring information/wage resetting the public may find it optimal to "look-through" shocks. This makes the policymaker's short-term interest rate instrument more effective in output stabilisation giving it greater leverage over the real rate. As a consequence, the variability trade-off is improved, i.e. volatility of both inflation and output is rediced in equilibrium. Our analysis thus adds another dimenstion to the "rule vs. discretion debate" by showing that a long-run rule may be compatible with (and in fact enhance the effectiveness of) short-run discretion. We conclude by showing that our results are consistent with several empirical findings of the literature.

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Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2006-02.

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Length: 41 pages
Date of creation: Jan 2006
Date of revision:
Handle: RePEc:een:camaaa:2006-02
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