Inexibility of Ination Targeting Revisited: Modelling the Anchoring E¤ect

Opponents of explicit in‡ation targeting (including ex-Chairman Greenspan) have argued that a commitment to a numerical in‡ation target reduces the policy’s ‡exibility, and may hence increase output volatility. Our paper demonstrates that this claim may fail to account for the anchoring e¤ect of explicit targets on expectations and wages (that has been established empirically in various studies). This is done in a novel, more dynamic game theoretic framework that incorporates the concept of ‘economically rational expectations’by making the frequency of players’moves (both the private sector’s and the central banker’s) endogenous. We show that under an explicit long-term in‡ation target and costly processing information/wage resetting, the public may …nd it optimal to look-through shocks and alter expectations and wages only infrequently. Due to such ‘rational inattention’, wages and expectations will be anchored at the target level, whereby the more explicit the target the stonger the anchoring. This is shown to make the policymaker’s short-term interest rate instrument more e¤ective in stabilization, giving it greater leverage over the real rate. As a consequence, an explicit in‡ation target improves the variability tradeo¤, ie it makes both in‡ation and output less variable in equilibrium. Our analysis thus adds another dimension to the ‘rule vs discretion debate’by showing that a long-run rule may be compatible with (and in fact enhance the e¤ectiveness of) short-run discretion. It further o¤ers several insights about the role of transparency and communication in the magnitude of the bene…cial anchoring e¤ect, and about the relationship between in‡ation targeting and central bank independence. We conclude by showing that our results are empirically supported. Keywords: explicit in‡ation targeting, stabilization ‡exibility, output volatility, nominal anchor, commitment, dynamic games, asynchronous moves, rule, discretion, wage rigidity. JEL classi…cation: E42, E61, C72 I would also like to thank Don Brash, Chris Carroll, Viv Hall, Andrew Hughes Hallett, Jonathan Kearns, Martin Melecky, Ben McCallum, Glenn Otto, Je¤ Sheen, the participants of the 11 Australasian Macroeconomics Workshop, the 24 Australasian Economic Theory Workshop, the 35 Australian Conference of Economists, the ZEI Summer School on Monetary Theory and Policy, and seminars at Victoria University of Wellington, the Reserve Bank of New Zealand, Deutsche Bundesbank, Dutch National Bank and Czech National Bank for their comments and suggestions. All remaining errors are mine. Please address correspondence to Jan Libich, La Trobe University, School of Business, Melbourne, Victoria, 3086, Australia. Phone: +61 3 24792754. Email: [email protected].