Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

What Difference Would an Inflation Target Make?

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

What Difference Would an Inflation Target Make?

Article excerpt

Numerous economists have advocated an inflation target for the United States (see, for example, Mishkin [1999] and Goodfriend [2005]). What, if anything, would an inflation target change about the way the Federal Reserve makes monetary policy? To answer this question, one must be explicit about the strategy used to achieve that target. Such a strategy might not even include inflation as an operational target. An answer to this question therefore requires specification of a policy rule-an explicit formulation of the objectives of monetary policy and the strategy for achieving those objectives.

A policy rule would clarify what, if anything, an explicit inflation target implies about other objectives. Are real output and unemployment also objectives? If a tradeoff between fluctuations of inflation around its target and fluctuations of real output around potential or trend output exists, real output and unemployment must be included as objectives along with inflation. Whether this tradeoff exists depends upon the structure of the economy. Therefore, to evaluate the prospective working of an inflation target requires explicit specification of both a policy rule and a model of the economy. Different models possess different implications for how a central bank would make an inflation target operational. How does one choose such a model?

There are two different frameworks for explaining how central banks control inflation. One framework makes an "exploitable" Phillips curve the central behavioral relationship in the control of inflation. That is, the central bank can use the real-nominal (unemployment-inflation) correlations in the empirical data as a reliable lever with which to trade off between these variables. The other tradition, the quantity theory, makes monetary control the central behavioral relationship. That is, to control inflation, the central bank must control the rate at which nominal money grows relative to real money demand by the public. The former tradition, but not the latter, implies that the control of inflation imposes a tradeoff between variability in real output and inflation.

Two problems arise in choosing the correct model. The first is the lack of consensus over the empirical generalizations that should serve as a basis for choosing one model over the other. What lessons does one draw from the recent historical experience in the United States of rising inflation followed by disinflation? How does one summarize this experience in a way that allows a choice between competing models?

Section 1 lists four empirical and theoretical generalizations that I consider consistent with this experience and with the quantity theory framework. Section 2 discusses the consensus that exists over these generalizations. (The central bank must provide a nominal anchor.) Section 3 discusses the disagreement. (What is the nature of the Phillips curve?)

The second problem is that no exposition of a model in the quantity theory tradition exists that is useful for explaining monetary control applicable to a central bank that uses an interest rate instrument. The central insight of the quantity theory is that the nominal quantity of money can change without a prior change in real money demand. When it does, the price level must change to restore the real quantity of money demanded by the public (Friedman 1969).1 However, existing expositions of the quantity theory assume that the central bank employs a money target. They leave unclear how a central bank, when it uses an interest rate instrument, achieves monetary control. That is, how does it avoid changes in money that produce undesired changes in prices?

Section 4 discusses monetary control when the central bank uses an interest rate instrument. Section 5 illustrates these ideas of monetary control through a model simulation that highlights periods when the central bank does and does not achieve its inflation target. The final section explains how an inflation target increases the demands placed on a central bank to communicate clearly to the public. …

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