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Estimating the Inflation-Output Variability Frontier with Inflation Targeting: A VAR Approach

This paper (i) illustrates how a VAR model can be used to evaluate inflation targeting, (ii) derives the policy frontier available to the central bank using counterfactual experiments with real time data, and (iii) estimates how this frontier has changed over time in terms of the position and slope of the available tradeoff between output gap variability and inflation variability under inflation targeting. Various inflation targets are considered as are tolerance bands of varying width around these targets. The results indicate that over time (i) a given reduction in inflation variability is associated with a smaller rise in output variability and that (ii) a given inflation variability is achieved with smaller interest rate volatility. Consistent with the data, our results require federal funds rate persistence, though no instrument instability was observed.

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File URL: http://www.bus.lsu.edu/economics/papers/pap07_04.pdf
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Paper provided by Department of Economics, Louisiana State University in its series Departmental Working Papers with number 2007-04.

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Handle: RePEc:lsu:lsuwpp:2007-04
Contact details of provider: Postal: Baton Rouge, LA 70803-6306
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Web page: http://www.business.lsu.edu/economics
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  15. Stephen G. Cecchetti & Michael Ehrmann, 1999. "Does Inflation Targeting Increase Output Volatility? An International Comparison of Policymakers' Preferences and Outcomes," NBER Working Papers 7426, National Bureau of Economic Research, Inc.
  16. Charles T. Carlstrom & Timothy S. Fuerst, 2005. "Considerable period of time: the case of signaling future policy," Economic Commentary, Federal Reserve Bank of Cleveland, issue Nov.
  17. Cecchetti, Stephen G, 1988. "The Case of the Negative Nominal Interest Rates: New Estimates of the Term Structure of Interest Rates during the Great Depression," Journal of Political Economy, University of Chicago Press, vol. 96(6), pages 1111-41, December.
  18. Athanasios Orphanides & David H. Small & Volker Wieland & David W. Wilcox, 1997. "A quantitative exploration of the opportunistic approach to disinflation," Finance and Economics Discussion Series 1997-36, Board of Governors of the Federal Reserve System (U.S.).
  19. Frederic S. Mishkin & Adam S. Posen, 1997. "Inflation targeting: lessons from four countries," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 9-110.
  20. Ben Bernanke, 1990. "The Federal Funds Rate and the Channels of Monetary Transnission," NBER Working Papers 3487, National Bureau of Economic Research, Inc.
  21. Leitemo, Kai, 2003. " Targeting Inflation by Constant-Interest-Rate Forecasts," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(4), pages 609-26, August.
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