Inflation Targeting in a St. Louis Model of the 21st Century

40 Pages Posted: 21 Apr 1998 Last revised: 30 Sep 2010

See all articles by Robert G. King

Robert G. King

Boston University - Department of Economics; Federal Reserve Bank of Richmond - Research Department; National Bureau of Economic Research (NBER)

Alexander L. Wolman

Federal Reserve Bank of Richmond

Date Written: March 1996

Abstract

Inflation targeting is a monetary policy rule that has implications for both the average performance of an economy and its business cycle behavior. We use a modern, rational expectations model to study the twin effects of this policy rule. The model highlights forward- looking consumption and labor supply decisions by households and forward-looking investment and price-setting decisions by firms. In it, monetary policy has real effects because imperfectly competitive firms are constrained to adjust prices only infrequently and satisfy all demand at posted prices. In this 'sticky price' model, there are also effects of the average rate of inflation on the amount of time that individuals must devote to shopping activity and on the average markup of price over cost that firms can charge. However, in terms of the welfare effects of long-run inflation, it is optimal to set monetary policy so that the nominal interest rate is close to zero, replicating in an imperfectly competitive model the result that Friedman found under perfect competition. A perfect inflation target has desirable effects on the response of the macroeconomy to permanent shocks to productivity and money demand. Under such a policy rule, the monetary authority makes the money supply evolve so a model with sticky prices behaves much like one with flexible prices.

Suggested Citation

King, Robert G. and Wolman, Alexander L., Inflation Targeting in a St. Louis Model of the 21st Century (March 1996). NBER Working Paper No. w5507. Available at SSRN: https://ssrn.com/abstract=3266

Robert G. King (Contact Author)

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
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617-353-5941 (Phone)

Federal Reserve Bank of Richmond - Research Department

P.O. Box 27622
Richmond, VA 23261
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Alexander L. Wolman

Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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