Working Paper: CEPR ID: DP6749
Authors: Volker Wieland
Abstract: This paper introduces adaptive learning and endogenous indexation in the New-Keynesian Phillips curve and studies disinflation under inflation targeting policies. The analysis is motivated by the disinflation performance of many inflation-targeting countries, in particular the gradual Chilean disinflation with temporary annual targets. At the start of the disinflation episode price-setting firms' expect inflation to be highly persistent and opt for backward-looking indexation. As the central bank acts to bring inflation under control, price-setting firms revise their estimates of the degree of persistence. Such adaptive learning lowers the cost of disinflation. This reduction can be exploited by a gradual approach to disinflation. Firms that choose the rate for indexation also re-assess the likelihood that announced inflation targets determine steady-state inflation and adjust indexation of contracts accordingly. A strategy of announcing and pursuing short-term targets for inflation is found to influence the likelihood that firms switch from backward-looking indexation to the central bank's targets. As firms abandon backward-looking indexation the costs of disinflation decline further. We show that an inflation targeting strategy that employs temporary targets can benefit from lower disinflation costs due to the reduction in backward-looking indexation.
Keywords: Disinflation; Indexation; Inflation Targeting; Learning; Monetary Policy; New Keynesian Model; Recursive Least Squares
JEL Codes: E32; E41; E43; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adaptive learning (D84) | lower costs of disinflation (E31) |
| central bank's inflation targeting strategy (E52) | firms adjust expectations regarding inflation persistence (D84) |
| firms adjust expectations regarding inflation persistence (D84) | switch from backward-looking indexation to central bank's targets (E52) |
| gradual disinflation strategy (E31) | lower costs due to learning dynamics (F12) |
| announcement of temporary inflation targets (E60) | quicker transition away from backward-looking indexation (P27) |
| quicker transition away from backward-looking indexation (P27) | reduced disinflation costs (E31) |