The Role of Inflation Target Adjustment in Stabilization Policy

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. Our proposed inflation target rule calls for the target 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-type rule, significantly reduces inflation fluctuations originating from cost-push shocks and mitigates the stabilization trade-off, resulting in a similar level of welfare to that associated with the Ramsey optimal policy.

Keywords: Cost-Push Shocks; Inflation-Output Trade-Off; Medium-Run Inflation Targeting; Welfare Analysis; Monetary Policy; Nominal Wage Rigidity; Capital Accumulation; Flat Phillips Curve

JEL Classification: E12; E32; E58; E61