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Inflation targeting and target instability

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  • Robert J. Tetlow

Abstract

Monetary policy is modeled as governed by a known rule, except for a time-varying target rate of inflation. The variable target is taken as representing either discretionary deviations from the rule, or as the outcome of a policymaking committee that is unable to arrive at a consensus. Stochastic simulations of FRB/US, the Board of Governors' large, rational-expectations model of the U.S. economy, are used to examine the benefits of reducing the variability in the target rate of inflation. We find that putting credible boundaries on target variability introduces an important non-linearity in expectations. This improves policy performance by focusing agents' expectations on policy objectives. But improvements are limited; it does not generally pay to reduce target variability to zero. The non-linearity in expectations can be used to conduct a policy with greater attention to output stabilization than otherwise. The results provide insights as to why inflation-targeting countries use bands and why the bands are narrower than studies suggest they should be. Also, a numerical technique that approximates to arbitrary precision a non-linear process with a linear method is also demonstrated. This greatly speeds the simulations and makes them more robust.

Suggested Citation

  • Robert J. Tetlow, 2000. "Inflation targeting and target instability," Finance and Economics Discussion Series 2000-01, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2000-01
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    References listed on IDEAS

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    Cited by:

    1. Andrew Levin & Volker Wieland & John C. Williams, 2003. "The Performance of Forecast-Based Monetary Policy Rules Under Model Uncertainty," American Economic Review, American Economic Association, vol. 93(3), pages 622-645, June.
    2. Ruge-Murcia, Francisco J, 2003. " Inflation Targeting under Asymmetric Preferences," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(5), pages 763-785, October.
    3. Oleg Korenok & Stanislav Radchenko, 2005. "Expectations Anchoring in Inflation Targeting Regimes," Working Papers 0503, VCU School of Business, Department of Economics.
    4. William C. Whitesell, 2005. "An inflation goal with multiple reference measures," Finance and Economics Discussion Series 2005-62, Board of Governors of the Federal Reserve System (U.S.).
    5. Felipe F. Schwartzman, 2005. "Inflation Target Zones As A Commitment Mechanism," Anais do XXXIII Encontro Nacional de Economia [Proceedings of the 33rd Brazilian Economics Meeting] 038, ANPEC - Associação Nacional dos Centros de Pós-Graduação em Economia [Brazilian Association of Graduate Programs in Economics].

    More about this item

    Keywords

    Monetary policy ; Inflation (Finance) ; Macroeconomics;

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling

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