INFLEXIBILITY OF INFLATION TARGETING REVISITED: MODELING THE "ANCHORING" EFFECT

Jan Libich

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

Abstract: Opponents of inflation targeting have argued that a commitment to a numerical inflation target reduces policy’s stabilization flexibility – increasing output volatility under supply shocks. Using a novel game theoretic approach our paper demonstrates that this claim may fail to account for the ‘anchoring’ effect of explicit targets on expectations and wages. Under a credible long-term inflation target and costly acquiring information/wage resetting the public may find it optimal to ‘look-through’ shocks. This makes policymaker’s short-term interest rate instrument more effective in output stabilization giving it greater leverage over the real rate. As a consequence, the variability trade-off is improved, i.e. volatility of both inflation and output is reduced in equilibrium. Our analysis thus adds another dimension to the ‘rule vs. discretion debate’ by showing that a long-run rule may be compatible with (and in fact enhance the effectiveness of) short-run discretion. We conclude by showing that our results are consistent with several empirical findings of the literature.

JEL-codes: C72 E42 E61 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2006-01
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Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2006-02

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