Drifting inflation targets and stagflation

Shujaat Khan and Edward Knotek

No RWP 12-10, Research Working Paper from Federal Reserve Bank of Kansas City

Abstract: The 1970s provided the United States its first experience with the phenomenon of stagflation?simultaneously high inflation and poor economic performance in terms of unemployment and GDP. Economists continue to debate the root causes of stagflation. The conventional view is that sharp increases in the price of oil during the decade were to blame: large increases in oil prices raise inflation, which saps purchasing power from consumers and businesses and thus hurts economic activity. But a number of economists also point to a role for monetary policy in generating stagflation, in particular through ?go-stop? monetary policy: because inflation tends to move slowly, a period of accommodative monetary policy followed by a sharp tightening of policy can result in stagflation, as output turns down quickly but inflation remains high from the ?go? phase. ; This paper examines the ability of monetary policy to generate stagflation. Using a relatively standard macroeconomic model, it shows that stagflation arises regularly in cases where the monetary authority allows its inflation target to move around. If households and firms face great uncertainty about the monetary authority?s inflation target, this scenario is also conducive to the emergence of stagflation?even if the inflation target actually remains unchanged. Thus, the paper finds that limiting monetary policy uncertainty and drift in the inflation target during normal times through clearly communicated, credible, and fixed inflation targets would essentially eliminate the possibility of stagflation from monetary factors.

Date: 2012
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