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Average Inflation Targeting and Interest-Rate Smoothing

Yunjong Eo () and Denny Lie ()

No 2019-15, Working Papers from University of Sydney, School of Economics

Abstract: We study the welfare implication of average inflation targeting as a simple interest-rate rule, in which the monetary authority adjusts its short-term policy rate in response to the output gap as well as average inflation deviation from its target instead of reacting to the contemporaneous inflation rate as in a Taylor-type rule. We find that the welfare improvement achieved by switching to average inflation targeting from a standard Taylor rule is modest with a high degree of interest-rate smoothing, whereas it is significant without interest-rate smoothing. We show that average inflation targeting is welfare-improving in the same way as interest-rate smoothing by making the conduct of monetary policy history-dependent. Thus, the high degree of monetary policy inertia in the estimated interest-rate rules in many advanced economies implies that the welfare gain from adopting the average inflation targeting rule would be modest.

Keywords: New Keynesian model; History-dependent policy; Welfare analysis; Ramsey policy; Interest-rate rule; Monetary policy inertia (search for similar items in EconPapers)
Date: 2019-11
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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Journal Article: Average inflation targeting and interest-rate smoothing (2020) Downloads
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