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Inflation Targets as Focal Points

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  • Maria Demertzis

    (De Nederlandsche Bank and University of Amsterdam)

  • Nicola Viegi

    (University of KwaZulu-Natal)

Abstract

In a world characterized by noisy information and conflicting signals, no central bank is able to affect private-sector expectations at all times. In order to evaluate the effectiveness of any central bank communication strategy, it is important to know what private agents rely on when they form expectations. We model monetary policy as an information game in which individuals form their expectations based on all the information that is available to them (public and private) and are, therefore, subject to the noise that characterizes that information. Individual agents also know that inflation is ultimately affected both by central bank policies and by the average expectation formed by all agents. The way individuals interpret these two components to form their expectations is explained in the context of a higher-order expectations setup and is central to our argument. We then apply Bacharach's (1993) variable-universe methodology to provide a framework for assessing everyone’s interpretations. Therefore, our contribution is, first, to describe monetary policy as an information game in which interpretations matter and, second, to provide a way of solving for these interpretations. We show that a monetary policy regime that has explicit quantitative objectives may provide individuals with better anchors for coordinating their expectations. However, that is only true either if no great shocks are anticipated or if all other public information is very unclear, leaving the inflation target as the only clear piece of information available. We derive the conditions under which this is true.
(This abstract was borrowed from another version of this item.)

Suggested Citation

  • Maria Demertzis & Nicola Viegi, 2005. "Inflation Targets as Focal Points," Money Macro and Finance (MMF) Research Group Conference 2005 52, Money Macro and Finance Research Group.
  • Handle: RePEc:mmf:mmfc05:52
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    More about this item

    JEL classification:

    • C71 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Cooperative Games
    • C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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