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Gaining Credibility for Inflation Targets

Listed author(s):
  • James Yetman

In this paper, I consider a simple model in which agents learn about the inflation target of a central bank over time by observing the policy instrument or inflation outcomes. Measuring credibility as the distance between the perceived target and the actual target, an increase in credibility is beneficial to the central bank because it brings the policy consistent with attaining the inflation target closer to that required to attain the output target. In this model, the crucial assumptions are that (1) the central bank knows what its target is, but lacks the means to credibly communicate this to agents; and (2) observed changes in the policy instrument are not perfectly informative to agents as to the objective of the central bank. Optimal monetary policy therefore entails endogenising the learning process of agents and solving the resultant "optimal control" problem. I show that a linear approximation to the optimal control problem is observationally equivalent to a "conservative central banker" in the sense of Rogoff (1985), and results in most of the gains that are available from pursuing a higher order approximation, and may actually be preferable if agents cannot determine the exact weights with which to update their view of the target. A conservative central banker is especially beneficial if society places a high weight on output deviations from target. I then illustrate the impact of other factors on credibility formation, including choice of monetary policy instrument, being transparent about the central bank's view of the economy, and publishing forecasts.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2001 with number 34.

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Date of creation: 01 Apr 2001
Handle: RePEc:sce:scecf1:34
Contact details of provider: Web page: http://www.econometricsociety.org/conference/SCE2001/SCE2001.html
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  1. Jon Faust & Lars E. O. Svensson, 1998. "Transparency and credibility: monetary policy with unobservable goals," International Finance Discussion Papers 605, Board of Governors of the Federal Reserve System (U.S.).
  2. Geraats, P.M., 2001. "Why Adopt Transparency? The Publication of Central Bank Forecasts," Papers 41, Quebec a Montreal - Recherche en gestion.
  3. Fuhrer, Jeffrey C. & Hooker, Mark A., 1993. "Learning about monetary regime shifts in an overlapping wage contract model," Journal of Economic Dynamics and Control, Elsevier, vol. 17(4), pages 531-553, July.
  4. Martin Evans & Paul Wachtel, 1993. "Inflation regimes and the sources of inflation uncertainty," Proceedings, Federal Reserve Bank of Cleveland, pages 475-520.
  5. Alan S. Blinder, 1999. "Central Bank Credibility: Why Do We Care? How Do We Build It?," NBER Working Papers 7161, National Bureau of Economic Research, Inc.
  6. Jean-François Fillion & André Léonard, 1997. "La courbe de Phillips au Canada : un examen de quelques hypothèses," Staff Working Papers 97-3, Bank of Canada.
  7. Alex Cukierman, 1992. "Central Bank Strategy, Credibility, and Independence: Theory and Evidence," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262031981, December.
  8. Graciela L. Kaminsky & Leonardo Leiderman, 1996. "High real interest rates in the aftermath of disinflation: is it a lack of credibility?," International Finance Discussion Papers 543, Board of Governors of the Federal Reserve System (U.S.).
  9. Goodfriend, Marvin, 1986. "Monetary mystique: Secrecy and central banking," Journal of Monetary Economics, Elsevier, vol. 17(1), pages 63-92, January.
  10. Stein, Jeremy C, 1989. "Cheap Talk and the Fed: A Theory of Imprecise Policy Announcements," American Economic Review, American Economic Association, vol. 79(1), pages 32-42, March.
  11. Duguay, Pierre, 1994. "Empirical evidence on the strength of the monetary transmission mechanism in Canada: An aggregate approach," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 39-61, February.
  12. Vickers, John, 1986. "Signalling in a Model of Monetary Policy with Incomplete Information," Oxford Economic Papers, Oxford University Press, vol. 38(3), pages 443-455, November.
  13. Kenneth Rogoff, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, Oxford University Press, vol. 100(4), pages 1169-1189.
  14. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
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