Long-run Inflation Target Research Articles

Endogenous growth and monetary policy: How do interest-rate feedback rules shape nominal and real transitional dynamics?

Monetary authorities have followed interest-rate feedback rules in apparently different ways over time and across countries, with the literature distinguishing, in particular, between active and passive monetary policies. We address the transitional-dynamics implications of these different types of monetary policy, in the context of a monetary growth model of R&D and physical capital accumulation. In this setup, well-behaved saddle-path transitional dynamics occurs under both active and (sufficiently) passive monetary policies – a relevant result little emphasised in the literature. We carry out our study from the perspective of a one-off shift in the structural stance of monetary policy (i.e., a change in the long-run inflation target) and a one-off shift in real industrial policy (i.e., an R&D or a manufacturing subsidy). We uncover a new channel through which institutional factors (the characteristics of the monetary-policy rule) influence the economies' convergence behaviour and through which monetary authorities may leverage (transitional) growth triggered by structural shifts.

Simple mandates, monetary rules, and trend-inflation

AbstractA mandate framework is proposed for delegating monetary policy to an instrument-independent, but goal-dependent central bank that emphasizes simplicity in both the objectives entering the welfare criterion and those in the instrument rule. It consists of: (i) a simple quadratic loss function penalizing deviations from target variables; (ii) a welfare-optimized, Taylor-type log-linear nominal interest-rate rule with targets that match those in the loss function; (iii) a zero-lower-bound (ZLB) constraint on the nominal interest rate imposing a low unconditional probability of ZLB episodes; and (iv) a long-run inflation target. In an estimated New Keynesian model with these features, we find that for a quarterly probability of 5%, an optimal annual inflation target is close to 2%, weights for real variables in the loss function are small compared with inflation except for the real wage growth mandate and the optimized rules mimic a price-level rule.

Existence and Uniqueness of Solutions to Dynamic Models with Occasionally Binding Constraints

We present the first necessary and sufficient conditions for there to be a unique perfect-foresight solution to an otherwise linear dynamic model with occasionally binding constraints, given a fixed terminal condition. We derive further results on the existence of a solution in the presence of such terminal conditions. These results give determinacy conditions for models with occasionally binding constraints, much as Blanchard and Kahn (1980) did for linear models. In an application, we show that widely used New Keynesian models with endogenous states possess multiple perfect foresight equilibrium paths when there is a zero lower bound on nominal interest rates, even when agents believe that the central bank will eventually attain its long-run, positive inflation target. This illustrates that a credible long-run inflation target does not render the Taylor principle sufficient for determinacy in the presence of the zero lower bound. However, we show that price level targeting does restore determinacy providing agents believe that inflation will eventually be positive.

The Long-Run and Short-Run Impacts of Investment, Export, Money Supply, and Inflation on Economic Growth In Indonesia

ABSTRACTThe development of investment and exports in Indonesia shows an increase, as well as money supply, while the inflation rate shows a decline, but this is not always followed by increasing economic growth. This study aims to explain the relationship between investment, export, money supply and inflation with the economic growth in Indonesia. The data used was time series data from the first quarter in 2001 to the fourth quarter in 2014 and was analyzed using multiple regression models with Error Correction Model (ECM) and classical assumptions. The study findings show that in short-term investment, export, money supply and inflation are not significant to economic growth. In long-run, investment has negative and significant effect on the economic growth, while export, money supply and inflation have positive and significant effect on the economic growth in Indonesia. Bank Indonesia must applied a tight money policy consistently to achieve the long-term inflation target ABSTRAKPerkembangan investasi dan ekspor di Indonesia menunjukkan peningkatan, demikian pula jumlah uang beredar, sementara tingkat inflasi menunjukkan penurunan, namun hal tersebut tidak selalu diikuti dengan meningkatnya pertumbuhan ekonomi. Studi ini bertujuan untuk menjelaskan hubungan antara investasi, ekspor neto, jumlah uang beredar dan inflasi terhadap pertumbuhan ekonomi di Indonesia. Data yang digunakan adalah data time series dari kuartal pertama tahun 2001 hingga kuartal keempat tahun 2014 dan dianalisa dengan menggunakan model regresi berganda dengan Error Correction Model (ECM). Hasil studi menunjukkan bahwa investasi, ekspor, jumlah uang beredar dan inflasi tidak signifikan terhadap pertumbuhan ekonomi di Indonesia dalam jangka pendek. Investasi berpengaruh negatif dan signifikan terhadap pertumbuhan ekonomi di Indonesia dalam jangka panjang, sedangkan ekspor , jumlah uang beredar dan inflasi berpengaruh positif dan signifikan terhadap pertumbuhan ekonomi di Indonesia. Bank Indonesia harus menerapkan kebijakan moneter yang ketat secara konsisten pada pencapaian sasaran inflasi jangka menenngah

The effects of secondary markets for government bonds on inflation dynamics

We analyze how trading in secondary markets for public debt changes the inherent links between monetary and fiscal policy, by studying both inflation and debt dynamics. When agents do not trade in these markets, there exists a unique monetary steady state and traditional passive/active policy prescriptions deliver locally determinate equilibria. In contrast, when agents trade in secondary markets and bonds are scarce, there exists a liquidity premium on public debt and bonds affect inflation dynamics and vice versa. In this monetary equilibrium, the government budget constraint can be satisfied for different combinations of inflation and debt. Thus, self-fulfilling beliefs that deliver multiple steady states are possible. Moreover, traditional passive/active policy prescriptions are not always useful in delivering locally determinate equilibria. However, monetary and fiscal policies can be used as an equilibrium selection device. We find that active monetary policies are more likely to deliver real and nominal determinacy when the long-run inflation target is low.

Trend inflation, firms' backward-looking behavior, and inflation gap persistence

In the macroeconomics literature, it is often believed that inflation persistence can be attributed to variations in the Federal Reserve's long-run inflation target rather than to firms' backward-looking pricing behavior. With this in mind, this paper investigates the need for a role of firms' backward-looking behavior in accounting for inflation persistence after trend inflation is eliminated from the inflation rate. Our findings are twofold. First, the observed low contemporaneous correlation and reverse dynamic correlation between the output gap and the inflation gap cannot be replicated by a standard dynamic stochastic general equilibrium (DSGE) model incorporating the purely forward-looking New Keynesian Phillips Curve (NKPC) and trend inflation. When the NKPC is replaced with its hybrid version, the DSGE model does provide a reasonable description of the observed joint dynamic correlation between the output and the inflation gaps. Second, the second moments of key macroeconomic variables are best explained by the hybrid NKPC emphasizing both firms' forward- and their backward-looking behaviors. These results dispute the view that trend inflation is able to replace the role of firms' backward-looking behavior in generating inflation persistence.

Structural Changes in Inflation Dynamics: A Bayesian Analysis Allowing for Multiple Breaks at Different Dates for Different Parameters

I make inferences about complicated patterns of structural breaks in inflation dynamics. I extend Chib's (1998) approach by allowing multiple parameters such as the unconditional mean, a group of persistence parameters, and/or the residual variance to undergo mutually independent structural breaks at different dates with the different number of breaks. Structural breaks are modeled as abrupt changes to identify potential regime shifts in economic structure such as a long-run inflation target, monetary policy, and price-setting behavior. I consider postwar quarterly U.S. inflation rates based on the CPI and the GDP deflator over the period from 1953:Q1 to 2013:Q4. I find that two inflation measures had distinct structural changes in different parameters as well as at different dates using Bayesian model selection procedures. CPI inflation experienced a dramatic drop in persistence around the early 1980s, but GDP deflator inflation is still persistent. In addition, the residual variance for both inflation measures switched from a low volatility regime to a high volatility regime in the early 1970s, but it returned to another low volatility regime at different dates: the early 1980s for GDP deflator inflation and the early 1990s for CPI inflation. The residual variance for CPI inflation has increased again since the early 2000s, while GDP deflator inflation has remained less volatile. These volatility shifts are confirmed by the empirical results based on the unobserved components model with stochastic volatility. However, I do not find evidence of a structural shift in the unconditional mean. When reviewing the recent literature, considerable controversy exists over the structural break in inflation persistence around the early 1980s but this appears to be dependent on the measures of inflation, as highlighted by the empirical findings in this paper.

The Case for a Long-Run Inflation Target of Four Percent

Many central banks target an inflation rate near two percent. This essay argues that policymakers would do better to target four percent inflation. A four percent target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. This benefit would come at minimal cost, because four percent inflation does not harm an economy significantly.

The Case for a Long-Run Inflation Target of Four Percent

The Case for a Long-Run Inflation Target of Four Percent

The Macroeconomics of Trend Inflation

Most macroeconomic models for monetary policy analysis are approximated around a zero inflation steady state, but most central banks target an inflation rate of about 2 percent. Many economists have recently proposed even higher inflation targets to reduce the incidence of the zero lower bound constraint on monetary policy. In this survey, we show that the conduct of monetary policy should be analyzed by appropriately accounting for the positive trend inflation targeted by policymakers. We first review empirical research on the evolution and dynamics of U.S. trend inflation and some proposed new measures to assess the volatility and persistence of trend-based inflation gaps. We then construct a Generalized New Keynesian model that accounts for a positive trend inflation. In this model, an increase in trend inflation is associated with a more volatile and unstable economy and tends to destabilize inflation expectations. This analysis offers a note of caution regarding recent proposals to address the existing zero lower bound problem by raising the long-run inflation target. (JEL E12, E31, E32, E52, E58)

Optimal long-run inflation and the New Keynesian model

Central banks typically have a long-run inflation target that is modestly positive. However, the standard New Keynesian framework prescribes that zero inflation is the optimal long-run target. In this paper, we show that when the baseline New Keynesian model is extended to allow for rule-of-thumb behavior by price setters, the optimality of zero long-run inflation ceases, and the monetary authority commits to a positive inflation target. The optimality of positive long-run inflation turns on the fact that the aggregate-supply relation does not imply an equivalence, up to first-order and regardless of policy, between the welfare-relevant measure of inflation and the discounted sequence of future output gaps.

Monetary policy rules in an OLG model with non-superneutral money

This paper considers an overlapping generations economy with capital accumulation and two outside assets (government bonds, fiat money) and compares the dynamic properties of two stylized monetary policy rules: (i) a constant money growth rule and (ii) an interest rate targeting rule which allows for an endogenous feedback to inflation. The results of this comparison depend strongly on whether under the overall monetary-fiscal regime long-run real interest rates are independent of inflation. If this is the case (i.e. superneutrality prevails) there exists in our model a unique and stable steady state under either monetary policy rule. By contrast, if superneutrality fails there is scope for much richer dynamics, characterized by multiple steady states and globally indeterminate dynamics. The paper offers a classification of such constellations and argues that under both monetary policy rules uniqueness and stability of steady states can be restored, provided the long-run inflation target and the feedback of the interest rate targeting rule are appropriately chosen.

Inflation Nutters? Modelling the Flexibility of Inflation Targeting

Opponents of explicit inflation targeting (including ex-Chairman Greenspan) have argued that a commitment to a numerical inflation target is likely to reduce monetary policy flexibility, and hence increase output volatility. Our paper demonstrates that this claim may fail to account for the anchoring effect of explicit targets on expectations and wages—found in the data by a number of empirical studies. We do so in a novel, dynamic game theoretic framework with asynchronous moves that endogenizes the frequency of the private sector’s actions. We derive the conditions under which an explicit long-term inflation target makes the behaviour of private agents rationally inattentive and anchored. This is through enhancing monetary policy credibility, which leads private agents to reconsider expectations and wages less frequently to minimize the cost of processing information and/or wage negotiations. Such anchoring makes the policymaker’s interest rate instrument more effective in stabilization, giving it greater leverage over the real rate. This implies that an explicit inflation target may improve the variability tradeoff, i.e. shift the policy frontier inwards. It can therefore make both inflation and output less variable in equilibrium, unlike what inflation targeting sceptics argue. We show that our results are consistent with existing empirical evidence, and discuss them in light of the global financial crisis. The policy implication is that the Federal Reserve, the Swiss National Bank, the Bank of Japan, and the European Central Bank should be more explicitly committed to a long-run inflation target.

An explicit inflation target as a commitment device

This paper shows an avenue through which a numerical long-run inflation target ensures low inflation and high credibility; one that is independent of the usual Walsh incentive contract. Our novel game theoretic framework – a generalization of alternating move games – formalizes the fact that since the target is explicit (legislated), it cannot be frequently reconsidered. This ‘explicitness’ therefore serves as a commitment device. There are two key results. First, it is shown that if the inflation target is sufficiently rigid/explicit relative to the public’s wages, low inflation is time consistent and hence credible even if the policymaker’s output target is above potential. Second, it is found that the central banker’s optimal explicitness level is decreasing in the degree of his patience/independence (due to their substitutability in achieving credibility). Our analysis therefore offers an explanation for the ‘inflation and credibility convergence’ over the past two decades as well as the fact that inflation targets were legislated primarily by countries that had lacked central bank independence like New Zealand, Canada, and the UK rather than the US, Germany, or Switzerland. We show that there exists fair empirical support for all the predictions of our analysis.

An Example of Robustly Optimal Monetary Policy with Near-Rational Expectations

This paper considers optimal monetary stabilization policy in a forward-looking model, when the central bank recognizes that private-sector expectations need not be precisely model-consistent and wishes to choose a policy that will be as good as possible in the case of any beliefs that are close enough to model-consistency. It is found that commitment continues to be important for optimal policy, that the optimal long-run inflation target is unaffected by the degree of potential distortion of beliefs, and that optimal policy is even more history-dependent than if rational expectations are assumed. (JEL: E52)

Robustly Optimal Monetary Policy with Near-Rational Expectations

The paper considers optimal monetary stabilization policy in a forward-looking model, when the central bank recognizes that private sector expectations need not be precisely model-consistent, and wishes to choose a policy that will be as good as possible in the case of any beliefs that are close enough to model-consistency. It is found that commitment continues to be important for optimal policy, that the optimal long-run inflation target is unaffected by the degree of potential distortion of beliefs, and that optimal policy is even more history-dependent than if rational expectations are assumed. (JEL C62, D84, E13, E31, E32, E52)

The Excess Sensitivity of Long-Term Interest Rates: Evidence and Implications for Macroeconomic Models

This paper demonstrates that long-term forward interest rates in the U.S. often react considerably to surprises in macroeconomic data releases and monetary policy announcements. This behavior is in contrast to the prediction of many macroeconomic models, in which the long-run properties of the economy are assumed to be time-invariant and perfectly known by all economic agents: Under those assumptions, the shocks we consider would have only transitory effects on short-term interest rates, and hence would not generate large responses in forward rates. Our empirical findings suggest that private agents adjust their expectations of the long-run inflation rate in response to macroeconomic and monetary policy surprises. We present an alternative model that captures this behavior. Consistent with our hypothesis, forward rates derived from inflation-indexed Treasury debt show little sensitivity to these shocks, indicating that the response of nominal forward rates is mostly driven by inflation compensation. In addition, we find that in the U.K., where the long-run inflation target is known by the private sector, long-term forward rates have demonstrated little excess sensitivity since the Bank of England achieved independence in mid-1997.

The Excess Sensitivity of Long-Term Interest Rates: Evidence and Implications for Macroeconomic Models

This paper demonstrates that long-term forward interest rates in the U.S. often react considerably to surprises in macroeconomic data releases and monetary policy announcements. This behavior is inconsistent with the assumption of many macroeconomic models that the long-run properties of the economy are time-invariant and perfectly known by all economic agents. Under those conditions, the shocks we consider would have only transitory effects on short-term interest rates, and hence would not generate large responses in forward rates. Our empirical findings suggest that private agents adjust their expectations of the long-run inflation rate in response to macroeconomic and monetary policy surprises. Consistent with our hypothesis, forward rates derived from inflation-indexed Treasury debt show little sensitivity to these shocks, indicating that the response of nominal forward rates is mostly driven by inflation compensation. In addition, we find that in the U.K., where the long-run inflation target is known by the private sector, long-term forward rates have not demonstrated excess sensitivity since the Bank of England achieved independence in mid-1997. We present an alternative model in which agents' perceptions of long-run inflation are not completely anchored, which fits all of our empirical results.

Inflation Forecasts and Monetary Policy

Proposals for 'inflation targeting' as a strategy for monetary policy leave open the important operational question of how to determine whether current policies are consistent with the long-run inflation target. An interesting possibility is that the central bank might target current private-sector forecasts of inflation, either those made explicitly by professional forecasters or those implicit in asset prices. We address the issue of existence and uniqueness of rational expectations equilibria when the central bank uses private-sector forecasts as a guide to policy actions. In a dynamic model which incorporates both sluggish price adjustment and shocks to aggregate demand and aggregate supply, we show that strict targeting of inflation forecasts is typically inconsistent with the existence of rational expectations equilibrium, and that policies approximating strict inflation-forecast targeting are likely to have undesirable properties. We also show that economies with more general forecast-based policy rules are particularly susceptible to indeterminacy of rational expectations equilibria. We conclude that, although private-sector forecasts may contain information useful to the central bank, ultimately the monetary authorities must rely on an explicit structural model of the economy to guide their policy decisions.

Sustainability of Macroeconomic Policies, Inflation Targeting, and Crowding out

Sustainability of Macroeconomic Policies, Inflation Targeting, and Crowding out