Does an inflation target zone help or hinder price stability?

Abstract

A significant number of central banks pursuing price stability operate an inflation target zone (ITZ) by letting inflation float within a band. The available literature is not conclusive on whether ITZs contribute to price stability. We elaborate and simulate a novel symmetric stochastic ITZ model inspired by the literature on exchange-rate agreements. Our new finding is that the performance of ITZs depends on whether the central bank sets the boundaries with certainty. In this case, it can accommodate larger shocks and set a lower interest rate at the point of intervention, with inflation remaining within the band and close on average to the central target. However, these benefits are reversed if the bandwidth is uncertain. Our simulations also show that a wider band leads to higher mean and variance of inflation, but it is still to be preferred to a narrow one if it is recognized as better defensible.