Working Paper: CEPR ID: DP1989
Authors: Lars E. O. Svensson
Abstract: The paper examines inflation targeting in a small open economy with forward-looking aggregate supply and demand with microfoundations, and with stylised realistic lags in the different monetary-policy transmission channels. The paper compares strict and flexible targeting of CPI and domestic inflation and inflation-targeting reaction functions and the Taylor rule. Flexible CPI-inflation targeting does not only limit the variability of CPI inflation but also the variability of the output gap and the real exchange rate. Negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap and induce similar monetary policy responses.
Keywords: Price Stability; Transmission Mechanisms
JEL Codes: E52; E58; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| strict CPI inflation targeting (E31) | greater variability in CPI inflation (E31) |
| strict CPI inflation targeting (E31) | greater variability in the output gap (E39) |
| strict CPI inflation targeting (E31) | greater variability in the real exchange rate (F31) |
| flexible CPI inflation targeting (E31) | stabilization of CPI inflation (E31) |
| flexible CPI inflation targeting (E31) | stabilization of the real exchange rate (F31) |
| negative productivity shocks (O49) | similar monetary policy responses (E63) |
| positive demand shocks (E00) | similar monetary policy responses (E63) |
| negative productivity shocks (O49) | inflation (E31) |
| positive demand shocks (E00) | inflation (E31) |
| negative productivity shocks (O49) | output gap (E23) |
| positive demand shocks (E00) | output gap (E23) |