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Inflation-Target Expectations and Optimal Monetary Policy

Sujit Kapadia

No 227, Economics Series Working Papers from University of Oxford, Department of Economics

Abstract: In countries with credible inflation targeting, it seems plausible to suggest that instead of forming a rational expectation, some firms (inflation-targeters) might simply expect future inflation to always equal its target. This paper analyses the implications of this for optimal monetary policy in a standard new-Keynesian model. Under discretion, we show that if shocks have any persistence, inflation is more stable, loss is reduced, and the optimal policy frontier is improved as the proportion of inflation-targeters increases. Considering the commitment case, we show that the benefits of commitment are diminished (stabilisation bias is reduced) in the presence of inflation-targeters, but overall loss is still reduced relative to the rational expectations benchmark for plausible parameter values and mild persistence in the shock. Taken together, these results formally illustrate how policies which encourage expectations anchoring may be beneficial for the economy.

Keywords: Inflation Targeting; Monetary Policy; Expectations; Stabilisation Bias (search for similar items in EconPapers)
JEL-codes: E52 E58 E31 E32 D84 (search for similar items in EconPapers)
Date: 2005-03-01
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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