Ination Targeting: Is the NKM t for purpose?

In this paper we examine whether or not the NKM is …t for the purpose of providing a suitable basis for the conduct of monetary policy through in‡ation targeting. We focus on a number of issues: the dynamic response of in‡ation to interest rates in a theoretical NKM under discretion and commitment to a Taylor rule; the implications for the speci…cation of the New Keynesian Phillips equation of alternative models of imperfect competition in a closed and an open economy; the general equilibrium underpinnings of the IS function; the extent of empirical support for the NKM; what the empirical evidence on the NKM implies for in‡ation targeting. Our …ndings reveal a number of problems with the NKM. Theoretically, the NKM predicts that a discretionary increase in interest rates will increase in‡ation, not reduce it. This is supported both by our empirical estimates of the NKM and by VAR results. We conclude that the standard speci…cations of the in‡ation and output equations are inadequate and that these equations should be embedded in a larger model.