Inflation Targeting and the Unemployment-Inflation Trade-off

IMF Working Papers, October 1, 2001

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This paper examines the impact of the introduction of inflation targeting on the unemployment-inflation trade-off in OECD countries.
Theoretical models suggest that the credibility-enhancing effects of the adoption of inflation targeting should cause an improvement in the unemployment-inflation trade-off, i.e., that reducing inflation by a given amount should occur with a smaller rise in unemployment.
The empirical evidence examined for OECD countries adopting inflation targeting supports this hypothesis.
Using a smooth transition regression model, it is shown that the improvement in this trade-off does not take place immediately after the adoption of inflation targeting; rather, it improves over time as the credibility of the central bank is established.

Empirical approach: smooth transition regression models.
Sample: OECD countries adopting inflation targeting (as described in the paper).

Credibility-enhancing adoption of inflation targeting is predicted to improve the unemployment-inflation trade-off.
Improvement is gradual and linked to the process of establishing central bank credibility rather than immediate upon adoption.

Adoption of inflation targeting can lead to better disinflation outcomes (lower inflation with smaller increases in unemployment) over time.
Policymakers should consider the time path of credibility formation when assessing the benefits of inflation-targeting regimes.

Inflation Targeting and the Unemployment-Inflation Trade-off -WP/01/166
- Inflation Targeting and the Unemployment-Inflation Trade-off -WP/01/166 (Markdown version)
- Inflation Targeting and the Unemployment-Inflation Trade-off -WP/01/166 (PDF)