## _wp0986 ## Source details **Canonical URL:** [_wp0986](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0986.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0986.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0986.pdf.json) --- ### I. Introduction - Observes a marked reduction in the rate of ination in both industrialized and emerging economies over the last two decades and a commitment by monetary authorities to maintain ination at a low level. - Chapter scope: - Discusses the costs of ination as the main element underlying the view that a high ination environment is unlikely to be conducive to a well-functioning economy. - Addresses the need for an economy to have a nominal anchor. - Sets out the intellectual roots of ination targeting (IT) and briey discusses what IT is and how it works. ### II. Costs of Inflation and Boom-Bust Cycles - Quantitative framing: - Low ination "clearly falls into the single digit levels" in both industrialized and emerging economies, and "is typically defined as low single digits for industrialized countries." - Hyperination defined as high triple-digit ination and above; introduces additional costs including currency substitution. - A. Costs of High Ination (enumerated findings) - Long-term decisions and volatility: - Long-term decisions by savers and investors are adversely affected because decisions rely on expected price movements and ination is associated with greater ination volatility. - Financing risks: - Long-term debt: exposed to losses from unexpected disination. - Short-term debt: exposed to funding risk. - Asset-price bubbles: - High ination periods tend to generate unrealistic expectations and can lead to asset price bubbles. - Capital stock and potential output: - Inationary distortions reduce the capital stock and/or its productivity, negatively affecting potential output. - Threshold evidence: Khan and Senhadji (2000) find the threshold to be "1-3 percent for industrial countries and 7-11 percent for developing countries, with a very wide confidence interval for the latter (1% to 20% confidence interval at a 90% condence region)." - Relative-price distortions: asynchronous price changes create welfare losses. - Interaction with taxation: ination affects depreciation, inventory valuation, interest treatment; individual income tax can tax the premium for expected ination (not real income). - Accounting, legal frameworks, and financial instruments: - Example: "30-year mortgage with 5% real rate and 10% ination (i.e., approximately 15% nominal interest rate)" — initial monthly payment is "approximately three times the initial monthly payment on a mortgage with the same real rate and no ination." - Interest rates and borrowing costs: - Long-term nominal rates = long-term real rate + expected ination + ination uncertainty risk premium. - Greater ination uncertainty raises the risk premium and real cost of borrowing. - Distributional consequences: - At 5% ination, a retiree with a nominal unindexed pension at age 60 will lose half the value of the pension by age 74 and three-quarters by age 88. - Labor negotiations: high ination and uncertainty increase strike days and bargaining difficulty. - B. Policy Credibility and Boom-Bust Cycles (enumerated findings) - High and volatile ination contributes to larger amplitude business cycles via price distortions leading to overinvestment followed by underinvestment. - Stop-go macro policies induced inefficient output and unemployment variability. - Historical evidence: - Canada: sharp declines in output and increases in unemployment in early 1980s and early 1990s following upward pressure on ination; milder cycles after taming ination. - United Kingdom: high unemployment variability through much of the postwar period; smoother path after achieving low ination and anchoring long-term ination expectations. - Model-based assessments: - Kumhof and Laxton (2007): better macro policies explained "about 50% of the overall improvement" in U.S. macro variability. - Stock and Watson (2003): conclude improved monetary policy did not account for much of the improvement; authors argue this ignores lags in re-anchoring expectations. - Laxton and N'Diaye (2002): re-anchoring took several years and required a track record on ination plus supporting fiscal, labor market, and product market policies. - Role of IT discussions: can refocus attention on monetary policy limits and complementary reforms. - Evidence from UK charts: lags between adoption of ination targeting in 1992 and credibility build-up, decline in long-term interest rates, and decline in the NAIRU. ### III. Need for A Nominal Anchor - Functions and benefits (enumerated) - Clarifies the central bank's intermediate or final objective internally and publicly. - Focuses internal deliberations and prevents divergent policy objectives. - Enhances external communication and rationale for instrument changes. - A credible numerical ination objective anchors long-term ination expectations. - Historical anchors and failures - Gold standard and pegging to a major currency historically served as anchors. - Post-Bretton Woods/1970s: monetary aggregate targeting attempted but failed due to instability in the demand for money amid deregulation and financial innovation. - By mid-1980s monetary targeting proved unsuccessful as a policy anchor. - Adoption of IT in the 1990s - Countries forced off fixed exchange rates (United Kingdom, Sweden, Finland) adopted IT after abandoning pegs. - Many emerging economies adopted IT later; some coexisted with exchange rate targets and shifted emphasis gradually. - Adoption circumstances varied: New Zealand and Canada moved absent a crisis; UK, Sweden, Brazil after forced exits; Israel and Chile transitioned gradually. - Current situation (as described) - No industrialized country currently uses a monetary aggregate as its policy anchor; prospects for returning are unlikely. - Most industrialized economies use flexible exchange rates or are in monetary unions; many use IT. - United States and Japan: committed to low ination but use more qualitative approaches without explicit quantitative targets. - Emerging economies: varied arrangements including continued use of monetary aggregates, fixed exchange rates, currency substitution, currency boards, monetary unions, and several midsized or larger emerging economies adopting IT. ### Adoption list and associated ratios (exact entries preserved) - 1. New Zealand1990 0.57Yes - 2. Canada1991 0.83 - 3. United Kingdom 1992 0.76 - 4. Sweden1993 0.79Yes - 5. Finland**1993 0.74 - 6. Australia1993 0.78 - 7. Spain***1995 0.65 - 8. Israel1997 0.55 - 9. Czech Republic 1998 0.50Yes - 10. Poland1998 0.34 - 11. Brazil1999 0.21 - 12. Chile1999 0.30 - 13. Colombia1999 0.14 - 14. South Africa2000 0.21 - 15. Thailand2000 0.17 - 16. Korea2001 0.52 - 17. Mexico2001 0.28 - 18. Norway2001 1.14Yes - 19. Iceland2001 0.84 - 20. Hungary2001 0.41 - 21. Peru2002 0.16 - 22. Philippines2002 0.07 - 23. Slovak Republic 2005 0.41 - 24. Indonesia2005 0.08 - 25. Romania2005 0.24 - 26. Turkey2006 0.27 - 27. Ghana2007 0.03 - Notes: - * Expressed as a ratio of 2006 per capita GDP in the United States - ** 1993-1998 (adopted Euro in 1999) - *** 1995-1998 (adopted Euro in 1999) - List based on an update of adoption dates reported by Roger and Stone (2005). Many countries started with simpler IT versions and improved frameworks over time. ### What Is Inflation Targeting? — definitions and characteristics - Core characteristics: - (i) public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more horizons. - (ii) explicit acknowledgment that low, stable inflation is monetary policy's primary long-run goal. - Additional features: - (iii) vigorous efforts to communicate plans and objectives to the public. - (iv) mechanisms strengthening central bank accountability for attaining objectives. - Mishkin (2007): IT is an information inclusive strategy using many variables, not just monetary aggregates or the exchange rate. - Clarification: announcing numerical one-year targets alone does not constitute full-fledged IT; other elements are required. - Emerging economies: may use "lighter" versions involving some exchange rate targeting or less transparency as preparation for or alternative to full-fledged IT. ### Box 2.1 — Six Principles of Inflation Targeting (as presented) 1. The primary role of monetary policy is to provide a nominal anchor for the economy and placing weights on other objectives must not be inconsistent with providing an anchor for inflation and inflation expectations. 2. An effective inflation-targeting regime will have beneficial first-order effects on welfare by reducing uncertainty, anchoring inflation expectations and reducing the incidence and severity of boom-bust cycles. 3. The success of an IT regime depends on other policies that make the task of monetary policy easier and more credible. 4. Because of the lags in the monetary transmission mechanism, and because of the concern with both the deviation of inflation from its target and the deviation of output from potential, it is neither possible nor desirable to keep inflation exactly on target and in practice inflation targeting becomes inflation-forecast targeting. 5. Given the possibility of conflict between inflation targets and other objectives, central bankers must have reasonably clear objectives and sufficient independence from the political process to achieve these objectives. 6. There must be effective monitoring and accountability mechanisms to ensure that central ### V. Two Key Intellectual Roots of Inflation Targeting - IT roots: - Absence of an exploitable long-run trade-off between output and inflation (Long-Run Natural Rate Hypothesis). - Time-inconsistency problem. - A. Absence of Long-Run Trade-Offs (model and illustrative findings) - Friedman (1968) and Phelps (1968): exploiting short-run trade-offs ratchets up expectations without long-run gains. - Stylized DSM (symbolic equations preserved): - π_t = E_t π_{t+1} + (1)π_{t-1} + y_t + "π_t - y_t = (i_t E_t π_{t+1}) +  y_{t-1} + "y_t - i_t = E_t π_{t+1} + (π_t π^*) +  y_t - Disturbances "π_t and "y_t are supply and demand shocks. - Taylor Principle: parameter  on deviation of inflation from target must be greater than 0 for system stability and anchoring. - Reduced-form inflation equation (as presented): π_t = !_0 π^* + !_1 π_{t-1} + !_2 y_{t-1} + !_3 "π_t + !_4 "y_t - Illustrative parameter experiment: - Assume DSM parameters equal to 0.5: (= = ====:5). - Disturbances "π_t and "y_t are normally and independently distributed with mean zero and variance equal to 1. - 40-quarter ahead model-consistent expectation of inflation is E_t π_{t+40}. - Comparison of two monetary policy regimes (Table 2 reproduced values): - Good Monetary Policy row: 0.40 0.60 0.32 1.20 0.63 1.73 0.79 0.000.80 - Bad Monetary Policy row: 0.03 0.97 0.94 1.94 1.88 16.70 1.15 4.82 31.33 - Good policy: !_0 = 0.40; !_1 = 0.60; anchors inflation and expectations; forecasts return to target over 4 to 6 quarters. - Bad policy: !_0 = 0.03; !_1 = 0.97; persistence close to a unit root; much greater persistence and variability. - Taylor Efficiency Frontiers (TEF): no exploitable long-run positive trade-off between levels of output and inflation; trade-off exists between variability of inflation and output; bad policies expand actual variability. - B. The Time-Inconsistency Problem (enumerated findings) - Kydland and Prescott (1977); Barro and Gordon (1983a, b): incentives to exploit short-run Phillips curve create inflation bias. - Policy responses: - Rogoff (1985): appoint conservative central bank governors. - Walsh (1995, 1998): design incentive structures for central bankers. - New Zealand example: early IT framework included a contract allowing the governor to be fired if inflation moved outside the band. - Practical measures: central bank independence, transparency, and accountability mitigate time-inconsistency and inflation bias. ### VI. How Does IT Work? (mechanisms and practices) - Flexible inflation targeting features: - Aim: achieve inflation target while avoiding excessive output and unemployment fluctuations. - Typical target horizon: "on the order of 6 to 8 quarters" in many industrialized countries. - Misses are rectified gradually; policy behaves as if minimizing a loss function with two arguments: variability of inflation around target and variability of output around capacity. - Responses to shocks: - Demand shocks: interest rate (and exchange rate) responses move output and inflation toward desired directions. - Supply shocks: pose trade-offs; credibility reduces need for large rate moves when medium-term expectations remain anchored. - Use of core inflation measures helps distinguish temporary supply-driven CPI movements from shocks affecting expectations. - Focus on expected future inflation: - Emphasis on expected future rate of inflation over the policy horizon rather than current rate due to policy lags and dual objectives. - Communications focus: forecast inflation over the policy horizon, policy-rate movements needed to achieve the target by end of that period, and medium-term nature of the framework. - Anchoring: successful early achievement of announced targets and transparency build anchored medium-term expectations. - Communications tactic example: to avoid generalized increases in expectations following a VAT/retail sales tax rise, central bank could emphasize accommodating first-round effects but responding to second-round effects. *IMF Working Paper _wp0986 (excerpt provided).* ### References.............................................................................................................. ### References ### I. Introduction - Over the last two decades, there has been a marked reduction in the rate of ination in both industrialized and emerging economies, and a commitment on the part of the monetary authorities in these countries to maintain ination at a low level. - The chapter: - Discusses the costs of ination as the main element underlying the view that a high ination environment is unlikely to be conducive to a well-functioning economy. - Addresses the need for an economy to have a nominal anchor. - Sets out the intellectual roots of ination targeting (IT) and briey discusses what IT is and how it works. - Related content and structure in the source: - Box 2.1: Six Principles of Inflation Targeting (page references indicate Box 2.1 appears earlier). - Figures listed: 1 through 5 (including "United Kingdom Inflation, Unemployment and Policy Credibility"). - Tables listed: Table 1 "Inflation Targeting Adoption Dates", Table 2 "Reduced-Form Inflation Equations Under Good and Bad Monetary Policy". ### II. Costs of Inflation and Boom-Bust Cycles - General observations: - Quantitative definition of low ination differs across countries but "clearly falls into the single digit levels" in both industrialized and emerging economies, and "is typically dened as low single digits for industrialized countries." - Hyperination (high triple-digit ination and above) introduces additional costs, including currency substitution. - Some costs may differ if a country's economic institutions are highly indexed. - A. What Are the Costs of High Ination? - Long-term decisions by savers and investors are adversely affected because decisions rely on expected price movements and ination is associated with greater ination volatility. - Financing risks: - Long-term debt: exposed to losses from unexpected disination. - Short-term debt: exposed to funding risk. - These risks reduce the likelihood of otherwise viable investment. - Asset-price bubbles: - High ination periods tend to generate unrealistic expectations about future asset prices and can lead to asset price bubbles. - Capital stock and potential output: - Inationary distortions reduce the capital stock and/or its productivity, negatively affecting the level of potential output. - Literature suggests a nonlinear relationship between ination and output growth with a threshold above which ination negatively affects growth: - Khan and Senhadji (2000) find the threshold to be "1-3 percent for industrial countries and 7-11 percent for developing countries, with a very wide confidence interval for the latter (1% to 20% confidence interval at a 90% condence region)." - Relative-price distortions: - Price changes are not synchronized across firms; relative prices can be distorted, causing welfare losses as agents respond to misleading signals. - Interaction with taxation: - Tax codes assume price stability; ination affects depreciation, inventory valuation, and interest treatment, producing overstatements and understatements of taxable income across firms, creating distortions. - Individual income tax: taxation of the premium for expected ination (not real income) constitutes a distortion. - Accounting, legal frameworks, and financial instruments: - Many frameworks and instruments assume price stability. - Example: fixed-nominal long-term mortgage—during moderate ination real payments are much higher in early years. - Example values: "30-year mortgage with 5% real rate and 10% ination (i.e., approximately 15% nominal interest rate)"—initial monthly payment is "approximately three times the initial monthly payment on a mortgage with the same real rate and no ination." - Interest rates and borrowing costs: - Long-term nominal rates = long-term real rate + expected ination + ination uncertainty risk premium. - Greater ination uncertainty raises the risk premium and real cost of borrowing, reducing aggregate investment. - As ination falls and expectations anchor, the risk premium declines and real borrowing costs fall. - Distributional consequences: - At 5% ination, a retiree with a nominal unindexed pension at age 60 will lose half the value of the pension by age 74 and three-quarters by age 88. - Lower-income individuals face greater difficulty protecting savings and incomes from ination; protective measures can be costly and socially wasteful. - Labor negotiations: - High ination and uncertainty make bargaining more difficult; days lost to strikes are typically larger at times of high ination than at times of low and more predictable ination. - B. Policy Credibility and Boom-Bust Cycles - High and volatile ination contributes to larger amplitude business cycles via price distortions that encourage overinvestment followed by underinvestment. - Stop-go macro policies (switching between expansionary and contractionary policies) induced inefficient output and unemployment variability. - Historical evidence: - Canada experienced sharp declines in output and increases in unemployment in the early 1980s and early 1990s following upward pressure on ination; milder cycles followed the taming of ination. - United Kingdom had high unemployment variability through much of the postwar period but a smoother path after achieving low ination and anchoring long-term ination expectations (see Figure 1: United Kingdom Ination, Unemployment and Policy Credibility). - Model-based assessments: - Kumhof and Laxton (2007) conclude that better macro policies explained "about 50% of the overall improvement" in U.S. macro variability. - Stock and Watson (2003) reach a contrasting conclusion that improved monetary policy did not account for much of the improvement; authors argue Stock and Watson do not account for the lag in re-anchoring long-term ination expectations. - Laxton and N'Diaye (2002) show the re-anchoring process took several years in most countries and required a track record on ination plus supporting fiscal, labor market, and product market policies. - Role of discussions about IT: - Debates on IT may refocus attention on the limitations of monetary policy and on complementary reforms to achieve real objectives such as lower unemployment. - Evidence from charts: - The UK charts illustrate lags between adoption of ination targeting in 1992 and the build-up in credibility, decline in long-term interest rates, and decline in the NAIRU. ### III. Need for A Nominal Anchor - Functions and benefits of a nominal anchor: - Clarifies the central bank's intermediate or final objective internally and publicly. - Helps focus internal deliberations and prevents divergent objectives among policymakers. - Enhances external communication of policy goals and rationale for instrument changes. - A credible numerical ination objective anchors long-term ination expectations and facilitates achieving the target. - Historical nominal anchors: - Gold standard and pegging to a major currency served as anchors in earlier periods. - Post-Bretton Woods and 1970s ination surge led to monetary aggregate targeting in some countries; monetary targeting failed due to instability in the demand for money (deregulation and financial innovation altered public holdings of financial assets). - Failure of monetary targeting: - By the mid-1980s, monetary targeting proved unsuccessful as a policy anchor. - In floating-exchange-rate countries with unstable monetary aggregates, qualitative commitments to low ination were insufficient to convince the public in countries with histories of high and volatile ination. - New Zealand and Canada adopted explicit quantitative paths for future ination to build credibility under flexible exchange rates. - Adoption of IT in the 1990s: - Some countries forced off fixed exchange rates (United Kingdom, Sweden, Finland) adopted IT after abandoning pegs. - Many emerging economies adopted IT later in the decade; some initially coexisted with exchange rate targets and only shifted emphasis gradually. - Adoption circumstances differ: some countries (New Zealand, Canada) moved to IT absent a crisis; others adopted IT following forced exit from fixed exchange rates (United Kingdom, Sweden, Brazil); others (Israel, Chile) transitioned gradually from exchange rate emphasis to IT. - Current situation (as described in the source): - No industrialized country currently uses a monetary aggregate as its policy anchor and prospects for returning to monetary aggregates are unlikely. - Most industrialized economies use flexible exchange rates or are in monetary unions; many use IT as the policy framework. - United States and Japan are committed to low ination but use a more qualitative approach without explicit quantitative targets. - Emerging economies exhibit varied arrangements: - Some still use monetary aggregates as anchors (often due to limited alternatives or capacity constraints). - Some use fixed exchange rates, currency substitution (dollarization/euroization), currency boards, or participation in monetary unions. - Several midsized or larger emerging economies have adopted IT as their nominal anchor (see Table 1: Inflation Targeting Adoption Dates). *Italic source-attribution: _wp0986 - References..............................................................................................................* ### 1. New Zealand1990 0.57Yes ### _wp0986 - 1. New Zealand1990 0.57Yes ### Adoption list and associated ratios - 1. New Zealand1990 0.57Yes - 2. Canada1991 0.83 - 3. United Kingdom 1992 0.76 - 4. Sweden1993 0.79Yes - 5. Finland**1993 0.74 - 6. Australia1993 0.78 - 7. Spain***1995 0.65 - 8. Israel1997 0.55 - 9. Czech Republic 1998 0.50Yes - 10. Poland1998 0.34 - 11. Brazil1999 0.21 - 12. Chile1999 0.30 - 13. Colombia1999 0.14 - 14. South Africa2000 0.21 - 15. Thailand2000 0.17 - 16. Korea2001 0.52 - 17. Mexico2001 0.28 - 18. Norway2001 1.14Yes - 19. Iceland2001 0.84 - 20. Hungary2001 0.41 - 21. Peru2002 0.16 - 22. Philippines2002 0.07 - 23. Slovak Republic 2005 0.41 - 24. Indonesia2005 0.08 - 25. Romania2005 0.24 - 26. Turkey2006 0.27 - 27. Ghana2007 0.03 Notes attached to the list: - * Expressed as a ratio of 2006 per capita GDP in the United States - ** 1993-1998 (adopted Euro in 1999) - *** 1995-1998 (adopted Euro in 1999) Additional contextual comment from the source: - This list is based on an update of the adoption dates reported by Roger and Stone (2005). - Many countries started with very simple versions of IT and then improved their frameworks over time—see Batini and Laxton (2007). - The adoption dates in Chapter 10 are based on the view of the national authorities and differ from those in this table for Chile and Israel. ### What Is Inflation Targeting? — definitions and characteristics - Inflation targeting (IT) is characterized by: - (i) the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and - (ii) the explicit acknowledgment that low, stable inflation is monetary policy's primary long-run goal. - Other important features include: - (iii) vigorous efforts to communicate with the public about the plans and objectives of the monetary authorities, and - (iv) mechanisms that strengthen the central bank's accountability for attaining those objectives. - Mishkin (2007) adds that inflation targeting is an information inclusive strategy in which many variables, and not just monetary aggregates or the exchange rate, are used for deciding the setting of policy instruments. - Mishkin's clarification: announcing numerical inflation targets for the year ahead alone does not constitute full-fledged inflation targeting; the other listed elements are required for sustainability over the medium term. - Emerging economies sometimes use "lighter" versions of IT: - These lighter versions may involve continuing some element of exchange rate targeting in addition to inflation targeting, or being less transparent in communications than full-fledged inflation targeters. - Lighter versions may be used as preparation for full-fledged IT (FFIT) or because of concerns about committing to FFIT. ### Box 2.1 — Six Principles of Inflation Targeting (as presented) - The design, implementation and evaluation of IT regimes can usefully be guided by the following six key principles. 1. The primary role of monetary policy is to provide a nominal anchor for the economy and placing weights on other objectives must not be inconsistent with providing an anchor for inflation and inflation expectations. 2. An effective inflation-targeting regime will have beneficial first-order effects on welfare by reducing uncertainty, anchoring inflation expectations and reducing the incidence and severity of boom-bust cycles. 3. The success of an IT regime depends on other policies that make the task of monetary policy easier and more credible. 4. Because of the lags in the monetary transmission mechanism, and because of the concern with both the deviation of inflation from its target and the deviation of output from potential, it is neither possible nor desirable to keep inflation exactly on target and in practice inflation targeting becomes inflation-forecast targeting. 5. Given the possibility of conflict between inflation targets and other objectives, central bankers must have reasonably clear objectives and sufficient independence from the political process to achieve these objectives. *Source: _wp0986 - 1. New Zealand1990 0.57Yes* ### 6. There must be effective monitoring and accountability mechanisms to ensure that central ### _wp0986 - 6. There must be effective monitoring and accountability mechanisms to ensure that central ### V. Two Key Intellectual Roots of Inflation Targeting - Inflation targeting (IT) has two key intellectual roots: - The absence of an exploitable long-run trade-off between output and inflation (Long-Run Natural Rate Hypothesis). - The time-inconsistency problem. #### A. Absence of Long-Run Trade-Offs - Core reasoning: - Friedman (1968) and Phelps (1968): exploiting a short-run trade-off between output and inflation leads to ratcheting up of inflation expectations and a return of output to its equilibrium level. - The LRNH posits short-run real effects of monetary policy but no sustainable long-run positive trade-off between output and inflation. - Stylized Dynamic Structural Model (DSM) representation (as presented): - Inflation equation with lagged inflation and dependence on output gap. - Output gap equation depending on the real interest rate and lagged output gap. - Interest rate reaction function where the real interest rate is related to the output gap and the deviation of inflation from target. - Key model equations (symbolic form as in source): - π_t = E_t π_{t+1} + (1)π_{t-1} + y_t + "π_t - y_t = (i_t E_t π_{t+1}) +  y_{t-1} + "y_t - i_t = E_t π_{t+1} + (π_t π^*) +  y_t - Disturbances: - "π_t and "y_t described as supply and demand shocks; the former creates negative correlation between output and inflation, the latter positive correlation. - Taylor Principle: - The parameter  on the deviation of inflation from target must be greater than 0 for system stability and for anchoring inflation and expectations (consistency with the First Principle of IT). - Reduced-form issues: - Any stable linear DSM will have a reduced-form econometric (RFE) representation in which endogenous variables are functions of state variables and disturbances. - Example reduced-form inflation equation (as presented): π_t = !_0 π^* + !_1 π_{t-1} + !_2 y_{t-1} + !_3 "π_t + !_4 "y_t - Illustrative parameter experiment: - Assume all DSM parameters equal to 0.5: (= = ====:5). - Disturbances "π_t and "y_t are normally and independently distributed with mean zero and variance equal to 1. - The 40-quarter ahead model-consistent expectation of inflation is E_t π_{t+40}. - Comparison of two monetary policy regimes (as summarized in Table 2): - Good monetary policy: - Reduced-form parameters: !_0 = 0.40; !_1 = 0.60. - Monetary policy anchors inflation and long-term expectations; inflation forecasts return to target over a 4 to 6 quarter horizon. - Inflation inertia remains (! _1 = 0.60) but with substantially less persistence and variability. - Bad monetary policy: - Very weak feedback:  = :001;  = 0 (interest-rate feedback on output gap effectively set to zero). - Reduced-form parameters: !_0 = 0.03; !_1 = 0.97 (persistence close to a unit root). - Much greater persistence and variability in inflation, output gap, and long-term inflation expectations. - Table 2 (reproduced values from source): - Column headings (as in source): π^* π_{t-1} y_{t-1} "π_t "y_t ε_π ε_y ε_π LTE SLRPC - Good Monetary Policy row: 0.40 0.60 0.32 1.20 0.63 1.73 0.79 0.000.80 - Bad Monetary Policy row: 0.03 0.97 0.94 1.94 1.88 16.70 1.15 4.82 31.33 - Note: the source emphasizes that misinterpreting reduced-form inflation equations can suggest a spurious long-run trade-off when monetary policy is actually providing an anchor. - Taylor Efficiency Frontiers (TEF): - There is not an exploitable positive long-run trade-off between levels of output and inflation, but a trade-off between the variability of inflation and output. - Efficient (good) monetary policies minimize variability in output and inflation; bad policies increase variability. - Historical interpretation: stagflationary supply shocks shifted TEF outward in the 1960s–1970s; inappropriate accommodation expanded actual variability beyond what was necessary. #### B. The Time-Inconsistency Problem - Origin: - Kydland and Prescott (1977); Barro and Gordon (1983a, b). - Core idea: - Even when policymakers understand the LRNH, nominal rigidities and distortions create incentives to exploit the short-run Phillips curve to push output above potential. - Rational agents anticipate higher inflation, producing an equilibrium with inflation bias and no long-run real gains. - Policy responses in the literature: - Rogoff (1985) suggested appointing conservative central bank governors who value low inflation more than the general public. - Subsequent work (Walsh 1995, 1998) focused on incentive structures for central bankers. - New Zealand’s early IT framework included a contract allowing the governor to be fired if inflation moved outside the band. - Practical implications: - The weight to place on the historical inflation-bias issue varies across countries. - Central bank independence, transparency, and accountability are practical measures to mitigate time-inconsistency and inflation bias. ### VI. How Does IT Work? - Flexible inflation targeting: - IT central banks aimed to achieve the inflation target while avoiding excessive fluctuations in output and unemployment. - Targets were set over a medium-term horizon: "on the order of 6 to 8 quarters" in many industrialized countries. - Misses were to be rectified gradually; policy behaves as if minimizing a loss function with two arguments: variability of inflation around target and variability of output around capacity (Svensson (1997) framework). - Response to demand shocks: - Interest rate response (and exchange rate response) to demand shocks moves output and inflation toward desired directions (a "divine coincidence" in some cases). - Example: a positive temporary demand shock raises output and inflation; raising interest rates brings demand back to potential and inflation back to target. - Response to supply shocks: - Supply shocks (e.g., higher inflation coupled with lower output) pose a more difficult trade-off: raising rates fights inflation but weakens demand; lowering rates supports demand but increases inflation pressure. - As IT central banks built credibility, medium-term inflation expectations remained anchored, reducing the need for large interest rate moves in response to temporary supply shocks. - Use of core inflation measures helped the public see through temporary supply-driven CPI movements and distinguish shocks that affect expectations from those that do not. - Focus on expected future inflation: - Because of policy lags and dual objectives (inflation deviation and output deviation), IT emphasizes the expected future rate of inflation over the policy horizon rather than the current rate. - Central bank communications focus on forecast inflation over the policy horizon, policy-rate movements needed to achieve the target by the end of that period, and the medium-term nature of the framework. - Anchoring of expectations: - Anchored medium-term inflation expectations result from successful early achievement of announced targets and transparency/communications. - An increase in inflation not accompanied by higher inflation expectations requires less interest rate tightening to return inflation to target than an increase accompanied by a rise in expectations. - Example communications tactic: to avoid generalized increases in inflation expectations following a VAT or retail sales tax rise, the central bank could emphasize accommodating first-round effects but responding to second-round effects. *Italic source attribution: IMF Working Paper _wp0986 (excerpt provided).* ### References ### References ### Inflation targeting and credibility - Alichi, A., H. Chen, K. Clinton, C. Freedman, M.J. Johnson, O. Kamenik, Turgut Kisinbay, and D. Laxton, 2009, "Ination-Forecast Targeting Under Imperfect Policy Credibility," Forthcoming IMF Working Paper. - Batini, N. and D. Laxton, 2007, ìUnder What Conditions Can Ination Targeting Be Adopted? The Experience of Emerging Markets,î in Monetary Policy under Ination Targeting, ed. by Frederick S. Mishkin and Klaus Schmidt-Hebbel (Chile: Banco Central de Chile), pp. 467ñ506. - Bernanke, B., T. Laubach, F., Mishkin, and A. Posen, 1999, "Ination Targeting: Lessons from the International Experience," (Princeton: N.J.: Princeton University Press). - Freedman, C., D. Laxton, and I. Otker-Robe, 2009, "On Developing a Full-Fledged Ination Targeting Regime: Doing What You Say and Saying What you Do," forthcoming Internet Book on Ination Targeting. - Mishkin, F., 2007, "Can Ination Targeting Work in Emerging Market Countries?" C. Reinhart, C. Vegh, and A. Velasco, eds.,Capital Flows, Crisis, and Stabilization: Essays in Honor of Guillermo Calvo, MIT Press. - Roger, S. and M. Stone, 2005, ìOn Target? The International Experience with Achieving Ination Targets,î IMF Working Paper No. 05/163, available at www.imf.org. - Stone, M.R., 2003, "Ination Targeting Lite," IMF Working Paper No. 03/12, available at www.imf.org - Svensson, L., 1997, "Ination Forecast Targeting: Implementing and Monitoring Infaltion Targets," European Economic Review, Vol. 41, No. 6, pp. 1111ñ46. ### Monetary policy theory, rules, and credibility - Barro, R. and D. B. Gordon, 1983a, ìPositive Theory of Monetary Policy in a Natural Rate Model,î Journal of Political Economy, Vol. 91 (August), pp. 589-610. - óóó, 1983b, "Rules, Discretion, and Reputation in a Model of Monetary Policy," Journal of Monetary Economics, Vol. 12, pp. 101ñ121. - Friedman, M., 1968, "The Role of Monetary Policy," American Economic Review Papers and Procedings, Vol. 58, No. 1, pp. 1ñ17. - Kydland, F.E., and E.C. Prescott, 1977, "Rules Rathe Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, Vol. 85, pp. 473ñ92. - Laxton, D. and P. N'Diaye, 2002, ìMonetary Policy Credibility and the Unemployment-Ination Nexus: Some Evidence from Seventeen OECD Countries,î IMF Working Paper 02/220, available at www.imf.org. - Lucas, R.E., 1976, "Econometric Policy Evaluation; A Critique," Carnegie-Rochester Conference Series on Public Policy, Vol. 1, pp. 19.46. - Phelps, E.S., 1968, "Money Wage Dynamics and Labor Market Equilibrium," Journal of Political Economy, Vol. 76 (4, Part 2), pp. 678ñ711. - Rogoff, K., 1985, "The Optimal Degree of Commitment to an Intermediate Target," Quarterly Journal of Economics, Vol. 100, pp. 169ñ90. - Sargent, T.J., 1971, "A Note on the 'Accelerationist' Controversy," Journal of Money, Credit, and Banking, Vol. 3, pp. 721ñ25. - Taylor, J., 1993, ìDiscretion Versus Policy Rules in Practice,î Carnegie-Rochester Conference Series on Public Policy, Vol. 39, pp. 195-214. - óóó, 1996, ìHow Should Monetary Policy Respond to Shocks While Maintaining Log-Run Price Stability - Conceptual Issues,î in Federal Reserve Bank of Kansas City, Achieving Price Stability, pp. 181-95 (Kansas City: Federal Reserve Bank of Kansas City). - óóó, 1998a, ìA Historical Analysis of Monetary Policy Rules,î in Monetary Policy Rules, ed. by J. B. Taylor (Chicago: Chicago University Press). - óóó, 1998b, ìThe Robustness and Efciency of Monetary Policy Rules as Guidelines for Interest Rate Setting By the European Central Bank,î IIES Seminar Paper No. 649. - óóó, 1999, Monetary Policy Rules, (Chicago: University of Chicago Press). - Walsh, C. 1995, "Optimal Contracts for Central Bankers," American Economic Reviwe, Vol. 85, No. 1 (March), pp. 150ñ67. - óóó, 1998, "Monetary, Theory, and Policy," (Cambridge, MA: MIT Press). ### Empirical macroeconomics, business cycles, and spillovers - Bayoumi, T., D. Laxton and P. Pesenti, 2004, ìBenets and Spillovers of Greater Competition in Europe: A Macroeconomic Assessment,î ECB Working Paper No. 341 and NBER Working Paper No. 10416. - Blanchard, O., and J. Gali, 2007, "Real Wages Rigidities and The New Keynesian Model," Journal of Money, Credit, and Banking, Vol. 39, Supplement 1, pp. 35ñ65. - Kumhof, M. and D. Laxton, 2007, ìImproved Macroeconomic PerformanceóGood Luck or Good Policiesî Box 5.2 of Chapter 5 of the October 2007 World Economic Outlook, International Monetary Fund, available at www.imf.org. - Longworth, D., 2002, ìInation and the Macroeconomy: Changes from the 1980 to the 1990s,î Bank of Canada Review (Spring). - Stock, J. and M. Watson, 2003, ìHas the Business Cycle Changed? Evidence and Explanations,î Federal Reserve Bank of Kansas City Symposium on Monetary Policy and Uncertainty: Adapting to a Changing Economy, August. - The Economist, 2006, ìBig Questions and Big Numbers-Economic Models,î Special Report, (July), pp. 67-69. ### Methods, software, and working papers - Juillard, M., 2008, ìDYNARE: A Program for Simulating and Estimating SDGE Modelsî, http://cepremap.cnrs.fr/dynare. - Khan, M., and S. Semlali, A., 2000, ìThreshold Effects in the Relationship Between Ination and Growth,î IMF Working Paper No. 00/110, available at www.imf.org. *Source: _wp0986 - References* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0986.pdf_