Inflation Targeting Under Imperfect Policy Credibility
IMF Working Papers, April 1, 2009
Source details
- Canonical URL
- Inflation Targeting Under Imperfect Policy Credibility
Other formats
Bibliographic details
- Published: April 1, 2009
- Series: IMF Working Papers
Summary / Model modifications
- The paper presents a model for Inflation Targeting under imperfect policy credibility.
- The conventional model is modified in three ways:
- an endogenous policy credibility process, by which monetary policy can gain or lose credibility over time;
- non-linearities in the inflation equation and in the credibility generating process;
- an explicit loss function.
- The model highlights problems associated with the practice of setting a series of rigid near-term inflation targets.
- Unfavorable supply shocks pose a difficult problem: an appropriate response involves an interest rate increase, some loss of output, and a period of increased inflation. A delayed response can result in a prolonged period of stagflation.
Key findings and takeaways
- Endogenous credibility: Policy credibility is modeled as a process that can evolve endogenously—monetary policy actions can increase or decrease credibility over time.
- Non-linearities: Introducing non-linearities in the inflation equation and the credibility-generating process alters policy trade-offs relative to linear models.
- Loss function: An explicit loss function is used to evaluate policy outcomes and trade-offs.
- Rigid near-term targets: Setting a series of rigid near-term inflation targets is problematic according to the model’s implications.
- Supply shocks and trade-offs:
- Appropriate response to unfavorable supply shocks: interest rate increase, some loss of output, and a period of increased inflation.
- Delayed response risk: a delayed policy response can lead to a prolonged period of stagflation.
Policy implications and recommendations
- Avoid rigid series of near-term inflation targets; allow flexibility to account for credibility dynamics and non-linear responses.
- Respond promptly to unfavorable supply shocks with higher interest rates, accepting some short-term output loss and temporary higher inflation to prevent prolonged stagflation.
- Incorporate credibility dynamics explicitly into policy frameworks and communications to manage expectations over time.
Scenarios and dynamics emphasized
- Immediate tightening in response to supply shocks:
- interest rate increase;
- some loss of output;
- a period of increased inflation.
- Delayed tightening:
- risk of a prolonged period of stagflation.