Expectations of Inflation, the Term Structure of Interest Rates and Monetary Policy

This paper provides a theoretical framework for understanding how monetary policy can be used to control expectations of inflation. We study a simple production economy with a cash-in-advance constraint in which monetary-fiscal policy is Ricardian. Agents’ expectations are modeled as probability distributions on a finite set of possible inflation rates. The monetary authority announces a public forecast of inflation to direct agents’ expectations, and a bond pricing (term structure of interest rates) policy to make the forecast credible. We study conditions under which an announced forecast is compatible with equilibrium—there must be enough weight on inflation to be compatible with a non-negative nominal interest rate. In a stationary setting we exhibit a rank condition on the payoff structure of the bonds which must be satisfied if the forecast is to be the unique probability distribution compatible with the bond pricing policy, thereby making it the only possible common expectation of inflation for the agents. The model thus provides a formal framework for understanding the conditions under which the policy of inflation targeting can be successful.