Academic journal article Journal of Money, Credit & Banking

Average Inflation Targeting

Academic journal article Journal of Money, Credit & Banking

Average Inflation Targeting

Article excerpt

THE PAST DECADE HAS seen a substantial reduction in inflation rates in the industrialized world. While the average annual rate of inflation among the 11 major industrialized countries was over 7.5% in 1973-87, it fell to below 3% in 1988-99. (1) With this reduction in inflation rates, the meaning of "price stability" has changed. During the high-inflation period, the strive for price stability most often meant simply an attempt to curtail the rate of increase in the price level. A stable price level was considered unattainable (and thus its desirability was not debated either). Now, in a low-inflation environment, calls for price stability increasingly mean exactly that, i.e., a stable level of prices.

Recent years has thus seen a renewed interest in the analysis of monetary policy geared towards achieving a stable level of prices. One strand of the literature has shed new light on the question of the relative merits of price level targeting and inflation targeting (see e.g., Dittmar and Gavin, 2000, Kiley, 1998, Svensson, 1999, Vestin, 2003). It has been demonstrated that a price level target can give a more favorable combination of variability in inflation and the output gap than an inflation targeting policy, when the central bank is constrained to act under discretion. The basic reason behind this result is that a price level target will cause inflation expectations to change in such a way as to help the monetary policy maker, the result being that policy does not have to react as strongly as otherwise. More formally, price level targeting introduces history dependence, which is a characteristic of commitment solutions as shown by Woodford (1999b).

In this paper we investigate a set of policies that, as we argue below, may be considered as lying between price level targeting and inflation targeting, namely average inflation targeting. By this we mean a policy where the central bank's objective is to keep average inflation measured over several years stable. There are several reasons why we believe this may be interesting. First, average inflation targeting also introduces history dependence, but to a varying degree, depending on the width of the window used when calculating the average inflation rate (see Nessen 2002). Therefore, it is of theoretical interest to see if average inflation targeting under discretion produces policy responses closer to the optimal, commitment responses. Second, since there is (at least) one central bank pursuing an average inflation target, the Reserve Bank of Australia, such a policy deserves to be analyzed. (2)

The results of the paper are the following. Most importantly, we show that a target for average inflation causes inflation expectations to change in such a way that the short-run trade-off faced by the monetary policymaker improves. This in turn leads to smoother policy responses and lower societal welfare losses. Thus, given the assumption that the optimal commitment solution cannot be achieved (e.g., due to institutional constraints), average inflation targeting is an example of a "modified" loss function, which when pursued in a discretionary setting produces more efficient outcomes than the discretionary pursuit of the true objective. (3) In a purely forward-looking model, such average inflation targets are more efficient than targets for the one-period inflation rate. But they are dominated by a price level target (i.e., the price level targeting case comes closer to the optimal commitment solution). However, we also show that in a model with both forward- and backward-looking components the relative merits of price level targets, inflation targets, and average inflation targets can change dramatically. In particular, we demonstrate that as the economy becomes more backward-looking, there are intermediate cases when an average inflation target provides more efficient outcomes than both a price level target and an ordinary one-period inflation target. …

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