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Inflation Targeting:
St. Louis Fed Working Papers

Resources from the Federal Reserve Bank of St. Louis

"Euro Membership as a U.K. Monetary Policy Option: Results from a Structural Model"
by Riccardo DiCecio and Edward Nelson, Working Paper 2009-012A, March 2009. Published: Chapter 11 in Europe and the Euro, Alberto Alesina and Francesco Giavazzi, eds., University of Chicago Press, 2010.

Abstract: Developments in open-economy modeling, and the accumulation of experience with the monetary policy regimes prevailing in the United Kingdom and the euro area, have increased our ability to evaluate the effects that joining monetary union would have on the U.K. economy. This paper considers the debate on the United Kingdom's monetary policy options using a structural open-economy model. We use the Erceg, Gust, and López-Salido (EGL) (2007) model to explore both the existing U.K. regime (CPI inflation targeting combined with a floating exchange rate), and adoption of the euro, as monetary policy options for the United Kingdom. Experiments with a baseline estimated version of the model suggest that there is improved stability for the U.K. economy with monetary union. Once large differences in the degree of nominal rigidity across economies are considered, the balance tilts toward the existing U.K. monetary policy regime. The improvement in U.K. economic stability under monetary union also diminishes if imports from the euro area are modeled as primarily intermediates instead of finished goods; or if we assume that the pressures reflected in foreign exchange market shocks, instead of vanishing with monetary union, are now manifested as an additional source of disturbances to domestic aggregate spending.

"An Overhaul of Doctrine: The Underpinning of U.K. Inflation Targeting"
by Edward Nelson, Working Paper 2007-026D, July 2007, Revised August 2008. Published: Economic Journal, June 2009.

Abstract: This paper argues that the inflation targeting regime prevailing in the United Kingdom is not the result of a change in policymaker objectives. By conducting an analysis of U.K. policymakers that parallels Romer and Romer's (2004) study of Federal Reserve Chairmen, I demonstrate that policymaker objectives have been essentially unchanged over the past five decades. Instead, the crucial underpinning of U.K. inflation targeting has been an overhaul of doctrine—a changed view of the transmission mechanism. This overhaul can be understood in terms of changes in policymakers' views on the values of a few key parameters in their specifications of the economy's IS and Phillips curves. Specifically, the changed views pertain to the issues of whether interest rates enter the IS equation, and the extent of policymaker influence on those rates; whether the level of the output gap appears in the Phillips curve when the gap is negative; and whether a speed-limit term matters for inflation dynamics. Contrary to conventional wisdom, changing views on the expected-inflation term in the Phillips curve do not play a role.

"U.K. Inflation Targeting and the Exchange Rate"
by Christopher Allsopp, Amit Kara and Edward Nelson, Working Paper 2006-030A, May 2006. Published: Economic Journal, June 2006.

Abstract: The United Kingdom's monetary policy strategy is one of floating exchange rates and inflation forecast targeting, with the targeted measure referring to consumer prices. We consider whether it is welfare-reducing to target inflation in the CPI rather than in a narrower index; and the role of the exchange rate in the transmission of monetary policy actions to CPI inflation. We argue that it is appropriate to model imports as intermediate goods rather than as goods consumed directly by households. This leads to a simpler transmission mechanism of monetary policy, while also offering a sustainable explanation for the weakness of the exchange rate/inflation relationship and making consumer price inflation an appropriate monetary policy target.

"Recent Developments in Monetary Macroeconomics and U.S. Dollar Policy"
by William T. Gavin, Working Paper 2005-062C, September 2005, Revised July 2007. Published: ICFAI Journal of Monetary Economics, August 2007.

Abstract: This paper summarizes recent developments in the theory and practice of monetary policy in a closed economy and explains what these developments mean for United States dollar policy. There is no conflict between what is appropriate U.S. monetary policy at home or abroad because the dollar is the world's key currency. Both at home and abroad, the main problem for U.S. policymakers is to provide an anchor for the dollar. Recent experience in other countries suggests that a solution is evolving in the use of inflation targets.

"The U.K.'s Rocky Road to Stability"
by Nicoletta Batini and Edward Nelson, Working Paper 2005-020A, March 2005.

Abstract: This paper provides an overview, using extensive documentary material, of developments in U.K. macroeconomic policy in the last half-century. Rather than focusing on well-known recent changes in policy arrangements (such as the introduction of inflation targeting in 1992 or central bank independence in 1997), we instead take a longer perspective, which characterizes the favorable economic performance in the 1990s and 2000s as the culmination of an overhaul of macroeconomic policy since the late 1970s. We stress that policymaking in recent decades has discarded various misconceptions about the macroeconomy and the monetary transmission mechanism that officials held in earlier periods. The misconceptions included: an underestimation of the importance of monetary policy in demand management until 1970; a failure to distinguish real and nominal interest rates until the late 1960s; the deployment until the mid-1980s of ineffective monetary control devices that did not alter the monetary base; and the adherence by policymakers in the 1960s and 1970s to nonmonetary views of the inflation process. We also consider developments in fiscal policy in light of changes in the doctrines underlying U.K. macroeconomic decisions.

"Inflation-Targeting, Price-Path Targeting and Indeterminacy"
by Robert D. Dittmar and William T. Gavin, Working Paper 2004-007B, March 2004, Revised December 2004. Published: Economics Letters, September 2005.

Abstract: In this paper, we examine the areas of indeterminacy in a flexible price RBC model with shopping time role for money and a central bank that uses an interest rate rule to target inflation and/or the price level. We present analytical results showing that, although inflation targeting often results in real indeterminacy, a price level target generally delivers a unique equilibrium for a relevant range of policy parameters.

"What Explains the Varying Monetary Response to Technology Shocks in G-7 Countries?"
by Neville R. Francis, Michael T. Owyang and Athena T. Theodorou, Working Paper 2004-002D, February 2004, Revised April 2005. Published: International Journal of Central Banking, December 2005.

Abstract: In a recent paper, Galí, López-Salido, and Vallés (2003) examined the Federal Reserve's response to VAR-identified technology shocks. They found that during the Martin-Burns-Miller era, the Fed responded to technology shocks by overstabilizing output, while in the Volcker-Greenspan era, the Fed adopted an inflation-targeting rule. We extend their analysis to countries of the G-7; moreover, we consider the factors that may contribute to differing monetary responses across countries. Specifically, we find a relationship between the volatility of capital investment, type of monetary policy rule, the responsiveness of the rule to output and inflation fluctuations, and the response to technology shocks.

"Inflation Targeting: Why It Works and How To Make It Work Better"
by William T. Gavin, Working Paper 2003-027B, September 2003, Revised September 2003. Published: Business Economics, April 2004.

Abstract: Inflation targeting has worked so well because it leads policymakers to debate, decide on, and communicate the inflation objective. In practice, this process has led the public to believe that the central bank has a long-term inflation objective. Inflation targeting has been successful, then, because the central bank decides on an objective and announces it, not because of a change in its day-to-day behavior in money markets or the way it reacts to news about unemployment or real GDP. By deciding on an inflation rate and announcing it, the central bank is providing information the public needs to concentrate expectations on a common trend. The central bank gains control indirectly by creating information that makes it more likely that people will price things in a way that is consistent with the central bank's goal.

The way to improve inflation targeting is to be more explicit about the average inflation rate expected over all relevant horizons. Building a target path for the price level, growing at the desired inflation rate, is the best way to institutionalize a low-inflation environment. In a wide variety of economic models, a price-path target mitigates the zero lower bound problem, eliminates worries about deflation, and improves the central bank's ability to stabilize the real economy.

"Gold, Fiat Money and Price Stability"
by Michael D. Bordo, Robert D. Dittmar and William T. Gavin, Working Paper 2003-014D, June 2003, Revised May 2007. Published: B.E. Journal of Macroeconomics: Topics in Macroeconomics, 2007.

Abstract: The classical gold standard has long been associated with long-run price stability. But short-run price variability led critics of the gold standard to propose reforms that look much like modern versions of price path targeting. This paper uses a dynamic stochastic general equilibrium model to examine price dynamics under alternative policy regimes. In the model, a pure inflation target provides more short-run price stability than does the gold standard and, although it introduces a unit root into the price level, it leads to as much long-term price stability as does the gold standard for horizons shorter than 20 years. Relative to these regimes, Fisher's compensated dollar (or pure price path targeting) reduces inflation uncertainty by an order of magnitude at all horizons. A Taylor rule with its relatively large weight on output leads to large uncertainty about inflation at long horizons. This long-run inflation uncertainty can be largely eliminated by introducing an additional response to the deviation of the price level from a desired path.

"Controlling Inflation after Bretton Woods: An Analysis Based on Policy Objectives"
by William T. Gavin, Working Paper 2000-007A, February 2000. Published: Chapter 3 in Inflation Targeting in Transition Economies: The Case of the Czech Republic, Warren Coats, ed., Czech National Bank and the International Monetary Fund, 2000.

Abstract: This paper reviews the inflation experience in the post-Bretton Woods era in the context of alternative central bank objectives. It summarizes research on inflation-targeting issues, especially those associated with stabilizing the price level. Generally, inflation-targeting schemes do not provide a nominal anchor unless the central bank is focusing strictly on the inflation target and ignoring unemployment and the business cycle. Research summarized in this article suggests that the most important step a central bank can take to improve policy is to decide on a long-term path for the price level. Being explicit about the desired path for the price level not only reduces inflation variability at all horizons, but also gives the policymaker more flexibility to pursue output stabilization goals.

"The Persistence of Moderate Inflation in the Czech Republic and the Koruna Crisis of May 1997"
by Ali M. Kutan and Josef C. Brada, Working Paper 1998-021A, 1998. Published: Prague Economic Papers, December 1999.

Abstract: Macroeconomic policy in the Czech Republic has been based on a fixed exchange rate for most of the post-1993 period and a conservative fiscal policy characterized by a government budget that was close to balance combined with a tight monetary policy that sought to maintain high interest rates and to restrict the growth of the money supply. Surprisingly, given the Czech Republic's good starting conditions for carrying out such a "soft landing" in its macroeconomic stabilization, the economy was hit by a speculative attack on the koruna in May 1997, and the economy, which had shown some signs of an increasing tempo of growth, appears to have slid into recession. At the same time, inflation has proven to be, while moderate by regional standards, surprisingly resistant to dropping below 10% per annum, thus leaving the Czech Republic in an undesirable state of "stagflation," with output declining, unemployment rising, and inflation accelerating.

In this paper we argue that, although the fixed nominal exchange rate policy may have been retained for too long, and that, while the mix of monetary and fiscal policies was inappropriate given the desire for a fixed nominal exchange rate, the key problem for Czech policy both before and after the abandonment of a fixed exchange rate policy was and is the persistence of a rate of inflation that exceeds that of its major trading partners by a large margin. After explaining the relationship between Czech inflation, exchange rate and macroeconomic policies and the crisis of May 1997, we examine some explanations for the persistence of inflation in the Czech Republic at a level around 10%. We close by examining the policy implications of our findings in the context of the Czech National Bank's new policy of inflation targeting.

"Dynamic Shoe-Leather Costs in a Shopping-Time Model of Money"
by Michael R. Pakko, Working Paper 1998-007A, May 1998.

Abstract: A general-equilibrium shopping-time model of money demand is used to obtain estimates of some dynamic costs of inflation under alternative monetary policy rules. After examining the welfare implications of steady-state inflation, dynamic welfare costs are evaluated for inflation-targeting and price-level targeting regimes in a stochastic setting in which agents are uncertain about the underlying inflation trend. The regimes are distinguished by the presence or absence of a unit root in the money supply and the price level. Uncertainty about the underlying inflation rate is introduced as a mechanism for modeling the role of policy credibility.

"Inflation Targeting in a Small Open Economy: Empirical Results for Switzerland"
by Michael Dueker and Andreas M. Fischer, Working Paper 1995-014A, 1995. Published: Journal of Monetary Economics, February 1996.

Abstract: This paper extends McCallum's (1987) nominal targeting rule to a small open economy by allowing for feedback from the exchange rate. Instead of setting parameters in a McCallum-type targeting rule and simulating, the parameters are estimated using a Markov switching model. We argue that a model of discrete parameter changes should be adept at capturing sudden changes in policy regime, such as changes in the degree to which monetary policy admits feedback from the exchange rate. We examine the legitimacy of an inflation targeting rule with occasional exchange-rate feedback to describe Swiss monetary policy over the past twenty years.