The Role of Inflation Target Adjustment in Stabilization Policy

42 Pages Posted: 7 Apr 2017 Last revised: 2 Jun 2019

See all articles by Yunjong Eo

Yunjong Eo

The University of Sydney - School of Economics

Denny Lie

The University of Sydney - School of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: April 6, 2017

Abstract

How and under what circumstances can adjusting the inflation target serve as a stabilization-policy tool and contribute to welfare improvement? We answer these questions quantitatively with a standard New Keynesian model that includes cost-push type shocks which create a trade-off between inflation and output gap stabilization. We show that this trade-off leads to a non-trivial welfare cost under a standard Taylor rule, even with optimized policy coefficients. We then propose an additional policy tool of an inflation target rule and find that the optimal target needs to be adjusted in a persistent manner and in the opposite direction to the realization of a cost-push shock. The inflation target rule, combined with a Taylor rule, significantly reduces fluctuations in inflation originating from the cost-push shocks and mitigates the policy trade-off, resulting in a similar level of welfare to that associated with the Ramsey optimal policy. The welfare implications of the inflation target rule are more pronounced under a flatter Phillips curve.

Keywords: Welfare analysis, Monetary policy, Cost-push shocks, Medium-run inflation targeting, Flat Phillips curve

JEL Classification: E12, E32, E58, E61

Suggested Citation

Eo, Yunjong and Lie, Denny, The Role of Inflation Target Adjustment in Stabilization Policy (April 6, 2017). CAMA Working Paper No. 27/2017 . Available at SSRN: https://ssrn.com/abstract=2948180 or http://dx.doi.org/10.2139/ssrn.2948180

Yunjong Eo (Contact Author)

The University of Sydney - School of Economics ( email )

Social Sciences Building (A02)
Sydney, NSW 2006
Australia

Denny Lie

The University of Sydney - School of Economics ( email )

Rm 370 Merewether (H04)
Sydney, NSW 2006 2008
Australia

Register to save articles to
your library

Register

Paper statistics

Downloads
35
Abstract Views
314
PlumX Metrics