## Inflation Targeting Under Imperfect Policy Credibility

_IMF Working Papers, April 1, 2009_

## Source details

**Canonical URL:** [Inflation Targeting Under Imperfect Policy Credibility](https://www.imf.org/en/publications/wp/issues/2016/12/31/inflation-targeting-under-imperfect-policy-credibility-22494)

## Other formats

- [Markdown version](/en/publications/wp/issues/2016/12/31/inflation-targeting-under-imperfect-policy-credibility-22494/index.md)
- [Structured JSON version](/en/publications/wp/issues/2016/12/31/inflation-targeting-under-imperfect-policy-credibility-22494/index.json)
- [Bundle manifest](/en/publications/wp/issues/2016/12/31/inflation-targeting-under-imperfect-policy-credibility-22494/bundle-manifest.json)

## 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.

---

## Content in this bundle

- **Wp0994**
  - [Wp0994 (Markdown version)](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0994.pdf.md){rel="alternate" type="text/markdown"}
  - [Wp0994 (PDF)](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0994.pdf){rel="external" type="application/pdf"}

---

_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/inflation-targeting-under-imperfect-policy-credibility-22494_