Inflation targeting with NAIRU uncertainty and endogenous policy credibility

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Stochastic simulations are employed to compare performances of monetary policy rules in linear and nonlinear variants of a small macro model with NAIRU uncertainty under different assumptions about the way inflation expectations are formed. Cases in which policy credibility is ignored or treated as exogenous are distinguished from cases in which credibility and inflation expectations respond endogenously to the monetary authorities’ track record in delivering low inflation. It is shown that endogenous policy credibility strengthens the case for forward-looking inflation forecast based rules relative to backward-looking Taylor rules.