Academic journal article Journal of Money, Credit & Banking

The Nonlinear Phillips Curve and Inflation Forecast Targeting: Symmetric versus Asymmetric Monetary Policy Rules

Academic journal article Journal of Money, Credit & Banking

The Nonlinear Phillips Curve and Inflation Forecast Targeting: Symmetric versus Asymmetric Monetary Policy Rules

Article excerpt

THE 1990S saw the introduction of explicit inflation targets for monetary policy in a number of countries viz. Australia, New Zealand, Canada, the United Kingdom, Sweden, Finland, and Spain. Inflation targeting has been introduced as a way of further reducing inflation and to influence market expectations, after disappointment with monetary targeting (New Zealand and Canada) or fixed exchange rates (United Kingdom, Sweden, and Finland).

The relation between inflation targets and central bank preferences has been thoroughly investigated. On one hand, there is a theoretical literature of Walsh (1995), Svensson (1997a) that concludes that inflation targets can be used as a way of overcoming credibility problems because they can mimic optimal performance incentive contracts.

On the other hand, there is an empirical literature (Bernanke et al. 1999), that looks whether inflation targets have been instrumental in reducing the policy-implied short-term trend rate of inflation. Broadly speaking, the evidence is that inflation targets have indeed brought about a change in policymaker's inflation preferences.

Unlike the relation between inflation targets and central bank preferences, a relatively underexplored issue is how to translate inflation targets into short-term interest rates. This is the issue of how to map explicit "targets" for monetary policy into monetary policy instruments, or how to implement an inflation-targeting framework. An exception is an important contribution by Svensson (1997b). Svensson shows that because of lags in the transmission process of short-term interest rates to inflation, inflation targeting implies inflation forecast targeting. In his analysis, the central bank's forecast becomes an explicit intermediate target and its optimal reaction function has the same form as the Taylor rule (1993). Bullard and Schaling (2001) augment the Svensson model with regime switching in productivity and calculate the optimal monetary policy rule in the altered environment. They find that a rule that incorporates leading indicators about regimes significantly outperforms the Taylor rule. They use this result to comment on the new economy events of the 1990s and the stagflation events of the 1970s.

Also, the 1990s have seen the development of the literature on the so-called nonlinear Phillips curve (Laxton, Meredith, and Rose, 1995, Clark, Laxton, and Rose 1995, 1996, and Bean, 1996). This literature puts the time-honored inflation output trade-off debate in a fresh perspective by allowing for convexities in the transmission mechanism between the output gap and inflation. More specifically, according to this literature positive deviations of aggregate demand from potential (the case of an upswing or boom) are more inflationary than negative deviations (downswings) which are disinflationary.

This paper marries both strands of literature. We extend the Svensson inflation forecast targeting framework with a convex Phillips curve. Using dynamic optimization techniques, we find that the form of the optimal monetary policy reaction function is asymmetric. That is, the interest rate is a nonlinear function of the deviation of the inflation rate from its target and the output gap. In addition, we show that with asymmetry, optimal monetary policy becomes more active as uncertainty about the impact of policy increases. We thus provide an important and novel theoretical reason why increased uncertainty can lead to more aggressive rather than toward more cautious optimal policies.

The paper is organized into three remaining sections followed by two appendices. In Section 1, we present the model. In Section 2, we analyze the asymmetric policy rule for the case of strict inflation targeting. In Section 3, we extend the analysis with additional stabilization goals with respect to output. Section 4 concludes, the appendices provide proofs behind key results.

1. INFLATION FORECAST TARGETING WITH A CONVEX PHILLIPS CURVE

The broad acceptance of the expectations-augmented Phillips curve and the associated "natural rate" hypothesis led to the important conclusion that a long-run trade-off between activity and inflation did not exist. …

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