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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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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
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  17. 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.
  18. 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.
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  20. John B. Taylor, 1994. "The inflation/output variability trade-off revisited," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, vol. 38, pages 21-24.
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