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Uncovering Financial Markets Beliefs About Inflation Targets

  • RUGE-MURCIA, Francisco J.

This paper exploits the term structure of interest rates to develop testable economic restrictions on the joint process of long-term interest rates and inflation when the latter is subject to a targeting policy by the Central Bank. Two competing models that econometrically describe agents’ inferences about inflation targets are developed and shown to generate distinct predictions on the behavior of interest rates. In an empirical application to the Canadian inflation target zone, results indicate that agents perceive the band to be substantially narrower than officially announced and asymmetric around the stated mid-point. The latter result (i) suggests that the monetary authority attaches different weights to positive and negative deviations from the central target, and (ii) challenges on empirical grounds the assumption, frequently made in the literature, that the policy maker’s loss function is symmetric (usually a quadratic function) around a desired inflation value.

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Paper provided by Universite de Montreal, Departement de sciences economiques in its series Cahiers de recherche with number 9803.

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Length: 37 pages
Date of creation: 1998
Date of revision:
Handle: RePEc:mtl:montde:9803
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