Inflation-Targeting | Macro Paper Warehouse

Inflation Targeting: A New Framework for Monetary Policy?

This 1997 Journal of Economic Perspectives essay by Ben Bernanke and Frederic Mishkin is a survey and policy assessment, not an empirical study: it draws on comparative experience across the eight economies that had formally adopted inflation targeting by 1997 (Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden, and the United Kingdom), on Germany and Switzerland as “hybrid” cases that pursue inflation goals through money-growth targets, and on existing empirical work, to assess inflation targeting (IT) as a framework for monetary policy. All eight direct targeters use CPI-based series (often “core” or “underlying” measures excluding food, energy, indirect taxes, or mortgage costs), set target levels at 4 percent or below, mostly as ranges rather than points, over horizons of one to four years, and retain short-run flexibility through supply-shock exclusions, target ranges, adjustable near-term targets, or explicit escape clauses. The paper’s central argument is that IT is best understood as “constrained discretion” — a third category distinct from both a mechanical policy rule and pure discretion, since it fixes the medium-term goal while leaving short-run tactics to the central bank’s judgment — and that it serves two functions: providing a nominal anchor that reduces uncertainty about future inflation, and creating transparency and accountability that can discipline policymakers against inflationary bias. The authors argue against treating IT as an exclusive single-goal rule, note that there is not yet evidence that IT countries have disinflated at lower sacrifice ratios than others or that announcing targets by itself moves private expectations, favor a positive target of roughly 2 percent over a zero target (citing CPI measurement bias of an estimated 0.5 to 2 percentage points per year, downward nominal-wage rigidity, and insurance against deflation), and express a mild preference for inflation targeting over nominal GDP targeting on grounds of data timeliness, the practical similarity in short-run flexibility, and public understandability, while arguing the pre-1997 Volcker-Greenspan Federal Reserve’s policymaking framework was already “de facto very similar to inflation targeting.”

Monetary Policy and Exchange Rate Volatility in a Small Open Economy

This paper builds a tractable, microfounded small open economy version of the Calvo staggered-price New Keynesian model – one economy among a continuum making up the world – and uses it to analyze rule-based monetary policy. Its first main result is that, under complete international asset markets and the paper’s specific preference and technology assumptions, the economy’s log-linearized equilibrium dynamics reduce to exactly the same two-equation “canonical” system used to study closed economies: a New Keynesian Phillips curve linking domestic (producer) inflation to the output gap, and a forward-looking dynamic IS equation, with openness and cross-country substitutability entering only through composite coefficients and world output entering only through the natural rate of interest. Its second main result, obtained for the special case of log utility and unit elasticities of substitution, is that once an appropriately chosen employment subsidy neutralizes both firms’ market power and the small open economy’s incentive to manipulate its terms of trade, the welfare-optimal policy is to fully stabilize domestic prices – strict domestic inflation targeting. The paper then uses a calibrated version of the model to compare this optimal benchmark with two simple, more standard policy rules (a domestic-inflation-based Taylor rule and a CPI-inflation-based Taylor rule) and an exchange rate peg, finding a systematic trade-off: regimes that stabilize domestic inflation and the output gap most successfully necessarily generate substantially more volatile nominal exchange rates and terms of trade, and vice versa, with the exchange rate peg delivering the worst welfare outcome of the three simple rules because its “excess smoothness” of the terms of trade – consistent with the Mussa (1986) puzzle – amplifies domestic inflation and output-gap volatility instead.

The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise Their Inflation Targets in Light of the Zero Lower Bound?

This 2012 Review of Economic Studies paper by Olivier Coibion, Yuriy Gorodnichenko, and Johannes Wieland asks what rate of steady-state (trend) inflation maximizes welfare in a New Keynesian DSGE model once the zero lower bound (ZLB) on nominal rates is explicitly modeled, rather than assumed away. The authors build a medium-scale NK model with Calvo staggered price-setting, habit formation in consumption, and a Taylor rule truncated at the ZLB, solving for ZLB episodes’ endogenous duration using the Bodenstein-Erceg-Guerrieri (2009) nonlinear algorithm; they calibrate the model to standard U.S. moments and to the historical post-WWII frequency of ZLB episodes, and evaluate welfare via a second-order approximation to utility that decomposes into a steady-state term (from Calvo price dispersion) and variance terms in the output gap, inflation, and consumption. In the baseline calibration the optimal trend inflation rate is 1.5% per year – “close to the bottom end” of the 1-3% target ranges central banks commonly use – because, although each ZLB episode is individually costly (an 8-quarter ZLB spell costs the equivalent of a 6.2% permanent consumption loss at 2% trend inflation), such episodes are calibrated to occur only about once every 20 years at 2% inflation, so the unconditional expected cost of the ZLB is small (0.08% of permanent consumption) relative to the perpetual costs of higher trend inflation (steady-state price dispersion, and a previously unidentified channel by which higher trend inflation makes inflation volatility itself more costly). The optimal rate proves robust to a wide range of alternative calibrations and extensions – remaining under about 3% even when the output-gap loss weight is scaled up 100-fold, capital is added (2.1%), parameter uncertainty is incorporated (1.9%, 90% CI [0.3%, 2.9%]), or the historical ZLB frequency is tripled – with the risk-premium shock’s persistence being the single most sensitive parameter (raising optimal inflation from 1.5% to 3% when its autocorrelation rises from 0.947 to 0.96). The rate is highly sensitive to the assumed monetary and fiscal policy regime, however: optimal inflation falls to about 0.2% under commitment to a stabilization policy, rises to 2.7% under discretion, and falls to well under 0.3% under even a modest price-level-targeting response, and it falls further still, to 0.3%, if downward nominal wage rigidity is added to the model. The authors caveat that their cashless-economy setup ignores the Friedman optimal-deflation motive and seigniorage, and that omitting endogenous countercyclical fiscal policy during ZLB episodes likely overstates both the cost of the ZLB and the resulting optimal inflation rate.

The Power of Open-Mouth Policies

When a central bank announces a policy it will not implement for some time, households and firms respond straight away. This paper measures how much of a policy’s effect arrives in that anticipation window. The obstacle is technical: an announced, dated, one-off policy change is not a recurrent draw from a stationary process, so it produces a nonstationary solution — a different decision rule in every period — that conventional methods, which construct a single time-invariant decision rule, cannot represent. The authors develop a perturbation-based extended function path (EFP) method to build that sequence of time-dependent decision rules, and apply it to a scaled-down replica of the Bank of Canada’s ToTEM projection model. Across five experiments they find the anticipation effects are large for two of them and modest for the other three: a gradual rise in the inflation target from 2% to 3% raises output by about 0.2% at its peak when implemented immediately and by about 0.3% when announced a year ahead, and forward guidance about lifting off from the effective lower bound raises the peak output response by about 70% when the return to the Taylor rule is postponed from four quarters to eight — while switching to a more aggressive Taylor rule, to price-level targeting or to average inflation targeting produces only minor anticipatory effects in an economy not otherwise hit by shocks. Comparing their solution with a Markov news-shock treatment of the same experiment, they find the Markov version “significantly overstates the importance of a given anticipated event”, with peak anticipation effects in investment five times larger, because a unit-root news process implies the effects persist forever. (The full text read for this summary is the authors’ manuscript of November 16, 2024, which carries the same abstract, model and five experiments as the published article; magnitudes may have moved in revision.)