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Inflation Targeting, Credibility, and Non-Linear Taylor Rules

  • Matthias Neuenkirch

    ()

    (Philipps-University Aachen)

  • Peter Tillmann

    ()

    (University of Giessen)

In this paper we systematically evaluate how central banks respond to deviations from the inflation target. We present a stylized New Keynesian model in which agents' inflation expectations are sensitive to deviations from the inflation target. To (re-) establish credibility, monetary policy under discretion sets higher interest rates today if average inflation exceeded the target in the past. Moreover, the central bank responds non-linearly to past inflation gaps. This is reflected in an additional term in the central bank's instrument rule, which we refer to as the "credibility loss." Augmenting a standard Taylor (1993) rule with the latter term, we provide empirical evidence for the interest rate response for a sample of five inflation targeting (IT) economies. We find, first, that past deviations from IT feed back into the reaction function and that this influence is economically meaningful. Deterioration in credibility (ceteris paribus) forces central bankers to undertake larger interest rate steps. Second, we detect an asymmetric reaction to positive and negative credibility losses, with the latter dominating the former.

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File URL: http://www.uni-marburg.de/fb02/makro/forschung/magkspapers/35-2012_neuenkirch.pdf
File Function: Fourth version, 2012
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Paper provided by Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung) in its series MAGKS Papers on Economics with number 201235.

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Length: 16 pages
Date of creation: 2012
Date of revision:
Publication status: Forthcoming in
Handle: RePEc:mar:magkse:201235
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