Implementing Optimal Policy through Inflation-Forecast Targeting

Abstract

In recent years, many central banks have adopted inflation-targeting frameworks for the conduct of monetary policy. These have proven in a number of countries to be effective means of first lowering inflation and then maintaining both low and stable inflation and inflation expectations, without negative consequences for the output gap. It has been less clear how effective these procedures are as ways of bringing about desirable transitory fluctuations in inflation and output in response to exogenous shocks. This chapter considers how inflation targeting should be conducted in order to achieve optimal short-run responses to shocks. It first discusses the disadvantages of purely forward-looking policy making and then examines the extent to which various alternative forms of inflation targeting can avoid stabilization bias, incorporate history dependence of the proper sort, and result in determinacy of the equilibrium. It also discusses optimal equilibrium responses to shocks, interest rates in an optimal equilibrium, the problem of indeterminacy, and forecast targeting as an approach to dynamic optimization.

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