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Why is Inflation Targeting Successful?: Analysis of Inflation Target Transparency

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  • Bedri Kamil Onur Tas

Abstract

Although there are many studies that empirically investigate the impact of Inflation Targeting (IT) on several aspects of the economy, the mechanisms through which IT improves the economic conditions are not studied extensively. A theoretical study is needed to present the dynamics of IT and uncover the reasons behind the success of IT. In this paper, we theoretically investigate the mechanisms through which IT effects the expectations of the public and achieve desired levels of inflation, inflation uncertainty and credibility. The study considers two mechanisms through which IT achieves its goals: (1) improvement in the credibility of the Central Bank (CB) (2) improvement in the ability of the central bank to alter the expectations of the public. To analyze these mechanisms, we construct and solve a model of asymmetric information and learning between the CB and the public. The source of the asymmetric information is the time-varying inflation targets of the CB. This paper theoretically investigates the effect of IT on the information dynamics between the Central Bank (CB) and the public. The paper introduces time-varying implicit inflation targets of the CB as the potential source of asymmetric information. Then, the model shows that IT central banks attain the desired outcomes because IT eliminates the asymmetric information about the implicit inflation targets of the CB and the frictions caused by that asymmetric information. Following the empirical findings of Ireland (2007) and Leigh (2008), we construct a model of asymmetric information and learning where the CB has an implicit inflation target and that target is unknown to the public. The model features two agents, the Central Bank (CB) and a representative private-sector agent. The information structure is hierarchical since the CB is assumed to possess private information that the private-sector agent tries to deduce by observing the CB’s actions. Hierarchical information structure is modeled as in Townsend (1983). The information structure consists of two steps: • The CB determines its inflation target of time t and uses a simple Taylor rule to determine the interest rate. . The CB follows an AR(1) rule for the inflation target as in Gurkaynak et al. (2005). (This target is announced to the public in the inflation targeting case). • The representative private-sector agent observes the interest rate and the inflation target.(in the inflation targeting case) and revises her inflation and output expectations. To analyze these mechanisms, we construct and solve a model of asymmetric information and learning between the CB and the public. The source of the asymmetric information is the time-varying inflation targets of the CB. The model depends on unobserved-components modelling with state-space representations. The model is solved using the Kalman filtering algorithm. The results present that IT countries attain the desired outcomes because IT eliminates the asymmetric information and the frictions caused by that asymmetric information. As a result, we propose and theoretically show that in non-IT countries the private agents are uncertain about the implicit inflation target of the CB and they construct their expectations about the target by following the actions of the CB. That learning dynamics increases the uncertainty and the level of inflation significantly. IT eliminates that uncertainty about the inflation target since the target is announced and becomes public information. The announcement of a credible target anchors inflation expectations as empirically shown by Gurkaynak et al. (2010) and lower levels of inflation and inflation uncertainty are achieved as a result. There are three main results of this paper. First, inflation and output expectations of the public are significantly affected by the inflation target under the case of IT. In other words, we theoretically present the mechanism through which IT anchors inflation and output expectations. Second, in the discretionary CB case, the private sector agent uses a filtered estimate of the inflation target of the CB to form her expectations which increases the variance (stability) of inflation expectations of the public. Finally, credibility of the CB is significantly affected by the target under the IT case. The CB can improve its credibility by announcing a credible target.

Suggested Citation

  • Bedri Kamil Onur Tas, 2014. "Why is Inflation Targeting Successful?: Analysis of Inflation Target Transparency," EcoMod2014 6725, EcoMod.
  • Handle: RePEc:ekd:006356:6725
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    References listed on IDEAS

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    1. Gürkaynak, Refet S. & Levin, Andrew & Swanson, Eric T, 2006. "Does Inflation Targeting Anchor Long-Run Inflation Expectations? Evidence from Long-Term Bond Yields in the US, UK and Sweden," CEPR Discussion Papers 5808, C.E.P.R. Discussion Papers.
    2. Aoki, Kosuke, 2003. "On the optimal monetary policy response to noisy indicators," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 501-523, April.
    3. Martin Melecký & Diego Rodríguez Palenzuela & Ulf Söderström, 2009. "Inflation Target Transparency and the Macroeconomy," Central Banking, Analysis, and Economic Policies Book Series, in: Klaus Schmidt-Hebbel & Carl E. Walsh & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series (ed.), Monetary Policy under Uncertainty and Learning, edition 1, volume 13, chapter 10, pages 371-411, Central Bank of Chile.
    4. Svensson, Lars E. O. & Woodford, Michael, 2003. "Indicator variables for optimal policy," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 691-720, April.
    5. Leigh, Daniel, 2008. "Estimating the Federal Reserve's implicit inflation target: A state space approach," Journal of Economic Dynamics and Control, Elsevier, vol. 32(6), pages 2013-2030, June.
    6. Alan S. Blinder, 2000. "Central-Bank Credibility: Why Do We Care? How Do We Build It?," American Economic Review, American Economic Association, vol. 90(5), pages 1421-1431, December.
    7. Faust, Jon & Svensson, Lars E O, 2001. "Transparency and Credibility: Monetary Policy with Unobservable Goals," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(2), pages 369-397, May.
    8. Kosuke Aoki & Takeshi Kimura, 2007. "Uncertainty about Perceived Inflation Target and Monetary Policy," Bank of Japan Working Paper Series 07-E-16, Bank of Japan.
    9. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    10. Refet S. Gürkaynak & Eric T. Swanson & Brian P. Sack, 2003. "The excess sensitivity of long-term interest rates: evidence and implications for macroeconomic models," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    11. Svensson, Lars E. O. & Woodford, Michael, 2004. "Indicator variables for optimal policy under asymmetric information," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 661-690, January.
    12. Kozicki, Sharon & Tinsley, P.A., 2005. "Permanent and transitory policy shocks in an empirical macro model with asymmetric information," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 1985-2015, November.
    13. Townsend, Robert M, 1983. "Forecasting the Forecasts of Others," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 546-588, August.
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    Keywords

    Calibration with US parameters. ; Monetary issues; Impact and scenario analysis;

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