Optimal Inflation Targeting Under Alternative Fiscal Regimes

Flexible inflation targeting has been advocated as a practical approach to the implementation of an optimal state-contingent monetary policy, but theoretical expositions reaching this conclusion have typically abstracted from the fiscal consequences of monetary policy. Here we extend the standard theory by considering the character of optimal monetary policy under a variety of assumptions about the fiscal regime, with the standard analysis appearing only as a special case in which non-distorting sources of government revenue exist, and fiscal policy can be relied upon to adjust so as to ensure intertemporal government solvency. Alternative cases treated in this paper assume that there exist only distorting sources of government revenue; that it may not be possible for tax rates to adjust in response to economic disturbances, except with delay; or even that fiscal policy is purely exogenous, so that the central bank cannot rely upon fiscal policy to adjust in order to maintain intertemporal solvency (a case emphasized in the critique of inflation targeting by Sims, 2005). We find that the fiscal policy regime has important consequences for the optimal conduct of monetary policy, but that a suitably modified form of inflation targeting will still represent a useful approach to the implementation of optimal policy. We derive an optimal targeting rule for monetary policy that applies to all of the fiscal regimes considered in this paper, and show that it involves commitment to an explicit target for an output-gap adjusted price level. The optimal policy will allow temporary departures from the long-run target rate of growth in the gap-adjusted price level in response to disturbances that affect the government’s budget, but it will also involve a commitment to rapidly restore the projected growth rate of this variable to its normal level following such disturbances, so that medium-term inflation expectations should remain firmly anchored despite the occurrence of fiscal shocks. ∗We thank Vasco Curdia and Mauro Roca for research assistance, and the National Science Foundation for research support. Since its adoption in Chile and elsewhere early in the 1990s, inflation targeting has become an increasingly popular approach to the the conduct of monetary policy worldwide. Most of the countries that have adopted inflation targeting judge the experiment favorably, at least thus far. In many countries the adoption of inflation targeting has been associated with reductions in both the average level and volatility of inflation. Inflation targeting has been especially successful in stabilizing inflation expectations, as one might expect, given the emphasis that is typically given to a clear medium-term commitment regarding inflation (while temporary departures from the inflation target are allowed), and the typical increase in the degree of communication by inflation-targeting central banks with regard to the outlook for inflation over the next few years. But is inflation targeting an approach to monetary policy that is equally suitable for all countries, regardless of the institutions that may exist in a given country, the disturbances to which a particular economy is subject, and the other policies that are pursued by that country’s government? A question that would seem particulary worthy of discussion is how a country’s fiscal policies might affect the suitability of inflation targeting as an approach to the conduct of monetary policy. The fiscal consequences of commitment to an inflation target have largely been neglected in the theoretical literature that develops the case for inflation targeting. Typically, the models used to analyze monetary stabilization policy abstract from the government’s budget and dynamics of the public debt altogether, so that any fiscal effects of monetary policy decisions are tacitly assumed to be irrelevant. And it may be an acceptable simplification to proceed in this way, if one is choosing a policy for an economy with sound government finances, by which we mean one for which relatively non-distorting sources of revenue exist and the political will to maintain government solvency need never be doubted. But countries differ in the degree to which such an idealization of the circumstances of fiscal policy is realistic; and especially as inflation targeting becomes popular in developing countries which have recently had serious problems with inflation exactly because of their precarious government finances, one may wonder how safe it is to ignore the interrelation between monetary and fiscal policy choices. See, for example, the comparison of inflation expectations in IT and non-IT countries by Levin et al. (2004). See, for example, King (1997), Svensson (1997, 1999, 2003), Woodford (2003, chaps. 7-8), Walsh (2003, chap. 11), or Svensson and Woodford (2005) for canonical examples of the theoretical case for some version of inflation targeting as an optimal policy.