Inflation targeting strategy and its credibility

TL;DR

This paper explores the credibility of inflation targeting strategies, analyzing how endogenous money supply, expectations, and external factors influence inflation dynamics and monetary policy effectiveness.

Contribution

It presents a new model incorporating both steady state and recovery dynamics under inflation targeting, considering credibility and external influences.

Findings

Inflation targeting's power increases with external inflation considerations.

Finite horizon assumptions make money supply exogenous eventually.

Policy adjustments become more complex with external inflation factors.

Abstract

The money supply is endogenous if the monetary policy strategy is the so called Inflation and Interest Rate Targeting, IRT. With that and perfect credibility, the theory of the price level and inflation only needs the Fisher equation, but it interprets causality in a new sense: if the monetary authority raises the policy rate, it will raise the inflation target, and vice versa, given the natural interest rate. If credibility is not perfect or if expectations are not completely rational, the theory needs something more. Here I present a model corresponding to this theory that includes both the steady state case and the recovery dynamics after a supply shock, with and without policy reactions to such a shock. But, under the finite horizon assumption for IRT, at some future point in time the money supply must become exogenous. This creates the incentive for agents to examine, as of today, statistics on monetary aggregates and form their forecasts of money supply growth and inflation rates. Additionally, inflation models of the small open economy allow us to deduce that the IRT in this case is much more powerful than otherwise, and for the same degree of credibility. But things are not necessarily easier for the monetary authority: it must monitor not only internal indicators, but also external inflation and its determinants, and it must, in certain circumstances, make more intense adjustments to the interest rate.