Working Paper: CEPR ID: DP1249
Authors: Lars E. O. Svensson
Abstract: Inflation target regimes (like those of Canada, Finland, New Zealand, Sweden and the United Kingdom) are interpreted as having explicit inflation targets and implicit output/unemployment targets. Without output/unemployment persistence, delegation of monetary policy to a discretionary instrument-independent central bank with an optimal inflation target can eliminate the discretionary inflation bias, mimic the optimal linear inflation contract suggested by Walsh and extended by Persson and Tabellini, and achieve the equilibrium corresponding to an optimal rule with commitment. Thus an `inflation target-conservative' central bank with an inflation target equal to the socially-best inflation rate less any inflation bias dominates a Rogoff `weight-conservative' central bank with increased weight on inflation stabilization, which suboptimally increases output/unemployment variability. With ouput/unemployment persistence a constant inflation target is equivalent to a constant linear inflation contract. They can both eliminate the average inflation bias but not the state-contingent part of the inflation bias. Inflation variability is too high, and output variability too low, compared to the equilibrium corresponding to an optimal rule. An optimal state-contingent inflation target can remove all inflation bias, but in contrast to an optimal state-contingent linear inflation contract it still leaves inflation variability too high. Delegation with an optimal state-contingent inflation target to a Rogoff `weight-conservative' central bank can then achieve the equilibrium corresponding to an optimal rule. Inflation targets may on average be exceeded, and they may have imperfect credibility. Nevertheless they may usefully reduce inflation, and they appear much easier to implement than linear inflation contracts.
Keywords: monetary policy rules; discretion
JEL Codes: E42; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Independent central bank (E58) | Reduced inflation bias (E31) |
| Central bank's weight on inflation stabilization (E52) | Inflation bias and output variability (E31) |
| Type of inflation target (E31) | Variability of inflation and output (E31) |
| Design of the inflation target (E52) | Improved economic stability (F69) |
| Credibility of inflation targets (E52) | Effectiveness in controlling inflation (E64) |