Inflation Target Uncertainty and Monetary Policy

I develop an extension of the standard New Keynesian model to monetary policy regime switching to study the impact of uncertainty around the future inflation target. First, I fully characterize how the responses of current inflation and output to inflation target uncertainty depend on the monetary policy rule. If monetary policy is passive, inflation may increase far beyond the anticipated increase in the inflation target, while a strong monetary response to expected inflation results in an immediate drop in the inflation rate. Next, I derive the optimal response of the central bank, which can be achieved by adjusting the current inflation target. A central bank unwilling to adjust the inflation target can optimally adjust other policy rule parameters and can often obtain comparatively similar welfare benefits. Finally, I examine the implications of a perfectly anticipated change in the inflation target and find it is likely to generate cyclical dynamics for inflation and output under a constant policy rule. An optimal time varying policy rule or uncertainty in the period of the inflation target change eliminates cyclical fluctuations and improves welfare.