Credibility of an Inflation-Targeting Regime

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Mishkins view (2011) before the recent crisis, inflation targeting was the standard framework for monetary policy with it being seen as highly successful in OECD countries, with low inflation and low variability of inflation. However the recent crisis not only crushed economic activity, creating the most severe world-wide economic contraction since the Great Depression, but it also seemed to destroy confidence in the ability of central bankers to effectively manage the economy. As a result central banks slashed their benchmark interest rates to what economists call ‘zero lower bound’. Unfortunately growth seemed unaffected and to have negative interest rates would lead only to depositors withdrawing their money out of banks and leading to…show more content…
Thus by altering the supply of money in the economy, spending and inflation could be controlled. Friedman’s fixed money rule proposed that in order to target a specific rate of inflation, central banks should gauge the money supply based on its relationship to macroeconomic variables. He suggested the idea of “setting the rate of monetary growth with the nominal interest rate at zero and merely reducing inflation rate π*, so that(1+r)(1+π^* )=1. (Smith p.296). Taylor rule on the other hand, basically stated that the CB should just alter the short-term interest rate in response to perceived deviations of inflation and output from their targets. In order to stabilize the economy in the short run and achieve its long-run goal for inflation. Thus the monetary policy rule proposed by Taylor is: i=r ̅+π+h(π-π^* )+b(y-y ̅) Where, h>0. b>0 The Taylor rule can be the optimal monetary policy, as the interest rate policy should follow a version of the Taylor rule. Since the equation calls for a positive value of h, a rise in the inflation rate should cause a rise in the real policy interest rate, and vice versa. If only the coefficients on the output and inflation gaps are chosen suitably to echo the way that these variables affect the future inflation rate. Unlike in a Rule regime, in a
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