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How Does Monetary Policy Change? Evidence on Inflation Targeting Countries

We examine the evolution of monetary policy rules in a group of inflation targeting countries (Australia, Canada, New Zealand, Sweden and the United Kingdom), applying a moment-based estimator in a time-varying parameter model with endogenous regressors. Using this novel flexible framework, our main findings are threefold. First, monetary policy rules change gradually, pointing to the importance of applying a time-varying estimation framework. Second, the interest rate smoothing parameter is much lower than typically reported by previous time-invariant estimates of policy rules. External factors matter for all countries, although the importance of the exchange rate diminishes after the adoption of inflation targeting. Third, the response of interest rates to inflation is particularly strong during periods when central bankers want to break a record of high inflation, such as in the UK or Australia at the beginning of the 1980s. Contrary to common wisdom, the response becomes less aggressive after the adoption of inflation targeting, suggesting a positive anchoring effect of this regime on inflation expectations. This result is supported by our finding that inflation persistence as well as the policy neutral rate typically decreased after the adoption of inflation targeting.

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Paper provided by Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies in its series Working Papers IES with number 2010/26.

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Length: 49pages
Date of creation: Oct 2010
Date of revision: Oct 2010
Handle: RePEc:fau:wpaper:wp2010_26
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