Inflation rules with consistent escape clauses

Abstract

Simple inflation targets may be supplemented with an escape clause to be invoked in case the economy is hit by a major supply shock. In this paper, consistent solutions to the Flood and Isard (1989, IMF Staff Papers, 36, 612–632) escape clause model are derived in the spirit of Lohmann (1990, American Economic Review, 82, 273–286). She shows that Flood and Isard's assumption of symmetric boundary values of shocks, outside of which the zero-inflation rule should be broken, is inconsistent as long as the employment target differs from the natural rate. However, she does not actually solve the model. Obstfeld (1991, NBER Working Paper, No. 3603) applies this framework to an exchange-rate escape clause but is unable to solve his model given a triangular distribution of the supply shocks. This paper shows how the model can be solved and the optimal escape clause derived assuming a uniform distribution. Numerical examples suggest that the optimal boundary values in the consistent model are highly asymmetric.