Keywords: Learning, natural rate of interest, natural rate of unemployment, rational expectations, monetary policy rules, uncertainty, bond prices.
Abstract: A central tenet of inflation targeting is that establishing and maintaining well-anchored
inflation expectations are essential. In this paper, we reexamine the role of key elements
of the inflation targeting framework towards this end, in the context of an economy where
economic agents have an imperfect understanding of the macroeconomic landscape within which
the public forms expectations and policymakers must formulate and implement monetary policy.
Using an estimated model of the U.S. economy, we show that monetary policy rules that would
perform well under the assumption of rational expectations can perform very poorly when we
introduce imperfect knowledge. We then examine the performance of an easily implemented policy
rule that incorporates three key characteristics of inflation targeting: transparency, commitment
to maintaining price stability, and close monitoring of inflation expectations, and find that all
three play an important role in assuring its success. Our analysis suggests that simple difference
rules in the spirit of Knut Wicksell excel at tethering inflation expectations to the central bank's
goal and in so doing achieve superior stabilization of inflation and economic activity in an
environment of imperfect knowledge.
Full paper (388 KB PDF)
| Full Paper (Screen Reader Version)
Home | FEDS | List of 2006 FEDS papers
To comment on this site, please fill out our feedback form.
Last update: May 22, 2006