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A Note on Inflation Targeting

Ching-Chong Lai & Juin-Jen Chang Version of record first published: 25 Mar 2010.

To cite this article: Ching-Chong Lai & Juin-Jen Chang (2001): A Note on Inflation Targeting, The Journal of Economic Education, 32:4, 369-380 To link to this article: http://dx.doi.org/10.1080/00220480109596115

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A Note on Inflation Targeting

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Ching-chong Lai and Juin-jen Chang

Absrracr: The authors present a pedagogical graphical exposition to illustrate the stabilizing effect of price target zones. Based on a textbook AD-AS apparatus, they find that authorities commitment to defend a price target zone will affect the publics inflation expectations and, in turn, reduce actual inflation. They also find that, when the economy experiences supply shocks, the announcement that the monetary authorities intend to defend a price target zone will reduce the variability of domestic prices but raise the variability of domestic output relative to a free-price regime. However, when the economy experiences demand shocks, a price target zone tends to lower the variability of both domestic prices and output relative to a free-price regime.
Key words: AD-AS apparatus, inflation expectations, inflation targeting JEL code: E52 The monetary authorities of some industrialized countries, including Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden, and the United Kingdom, recently have taken a more active role in the management of consumer prices. Typically, they announce a specific band within which consumer prices are allowed to adjust freely for a given time horizon. Once consumer prices reach the bounds of the target zone, the monetary authorities intervene in the money market to adjust the money supply. The motivation for such announcements is that the authorities commitment will affect the publics inflation expectations and, in

Ching-chong h i is u reseurch fellow of econonrics ar Sun Yut-SenInstitute for Sociul Sciences und Philosophy, Acudenriu Sinicu (e-nlail: ccbi@ssp.sinicu.edu.hU). und Juin-jen Chang is an assistant professor of econonrics ut Fu-Jen Cutholic University, Tuiwun. The uuthors are indebted to Hirschel Kasper and three anonymous referees for their constructive suggestions and insightful conrnwnts. We wish to thunk Yi-ring Chen for helpful discussions.

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turn, reduce actual inflation.*So far, inflation-targeting countries generally have had a good performance in fulfilling the target they set. Observing this fact, Leiderman and Svensson (1995, 15) recognize that over time there seems to be a trend of more countries attempting to achieve and maintain low inflation with the help of explicit inflation targets for monetary policy. In his popular money and banking textbook, Mishkin (1998, 500) points out that inflation targets might become the wave of the future for central bank strategy. Our purpose in this article is to present a pedagogical graphical exposition to illustrate two related issues concerning inflation targets. It is widely known that the publics inflation expectations are crucial for inflation-targeting countries to keep the prices at a moderate level. Therefore, the first issues we address are why the authorities announcement affects the publics inflation expectations, and how the public reacts to this announcement. In addition, the experience of inflation-targeting countries, for example, Canada and New Zealand, would lead to achieving reductions in price fluctuation at the cost of increases in output fluctuation. The next issue deals with whether this price control policy has stabilizing effects on the relevant macro variables. We will also address whether the stabilizing effects of inflation targeting are related to the type of random shocks and the credibility of policymakers. INFLATION TARGET ZONES The theoretical model is made as simple as possible. The economy can be represented by the aggregate supply and aggregate demand functions:

a>O, y = p(m - p ) + F + p;
y=cy,+&;

(1)

p > 0, y > 0.

(2)

The variables are defined as follows: y equals real output, measured in natural logarithms; p equals price level, measured in natural logarithms; m equals nominal money supply, measured in natural logarithms; IF equals expected inflation rate; E equals random disturbance terms of aggregate supply; and p equals random disturbance terms of aggregate demand. Equation ( I ) is the aggregate supply function in which aggregate production is specified to be positively related to prices (01 > 0). The rationale for this setting can be justified by the fact that workers have imperfect information about price changes or their wages are set with contracts.3 Equation (2) is the aggregate demand function. It is a straightforward extension of the standard IS-LM model. In the goods market, the consumption expenditure is an increasing function of real output y, and investment is a decreasing function of the real interest rate R xe, where R is the nominal interest rate.4 In the money market, real money demand is positively related to y, but is negatively related to R. On the supply side of the money market, we assume for simplicity that the money stock is controlled unilaterally by the central bank. Putting both markets together and eliminating the nominal interest rate between them, we can represent the aggregate demand function for the economy most conveniently by the linear relationship
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stated in equation (2). Because a rise in the expected inflation rate leads to a fall in the real interest rate, hence boosting the investment activities, equation (2) specifies that aggregate demand is an increasing function of xe (y> 0). Moreover, an increase in real money supply lowers the nominal interest rate (hence the real interest rate). This, in turn, increases investment, raising aggregate demand. As a consequence, equation (2) specifies that aggregate demand is an increasing function of real money supply In - p (p > 0). In addition, the economy experiences both the supply shock E and the demand shock p. To focus on the essentials, we assume that the change of the supply shock E follows a discrete-state random walk. To be specific, in each step the supply shock E moves either up or down by the same step-length with the same probability, 1/2. As exhibited in Figure 1, at step 1, the supply shock begins at a known level E,, and may move either up to E, or down to E, with the same distance [i.e., E, - c0 = -(E, - Eo)], each with probability 1/2. In addition, it is assumed that the probability that E moves up or down in each step is independent of what happened in the previous steps. Analogously, at step 2, E, will move up to E,) with probability 1/2, and will move down to E~ with probability 1/2. It is clear in Figure 1 that at any step the mean of the supply shock E is its initial level.5For example, at step 1, the mean of E at Eo is E&= &,/2+ E2/2); at step 2, the mean of E at

FIGURE 1 Random Walk Representation

Step 1

Step 2

Step 3

Step 4

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E,

is &,(= 6 2 + c3/2).Accordingly, the expected change of E at any step is zero. For example, at step 1, the expected change of E at e0 is

At step 2 the expected change of

Eo 9 -&I
L
+ -

E at

is

, I L

= 0.

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The same characteristics of distribution apply to the aggregate demand shock p. We now use a textbook graphical presentation to address the stabilizing effect of inflation target zones. In Figure 2, the AS curve represents the pairs of output and prices that satisfy the aggregate supply function. The AD curve traces the loci of output and prices that satisfy the aggregate demand function. Assume that the monetary authorities announce that they stand ready to adjust the money supply when the level of prices exceeds the upper bound or falls short of the lower bound e.6Although the price is in the interior of the band 0, the monetary

FIGURE 2

The Stabilizing Effect of Inflation Targeting: A Supply Shock

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authorities do not alter the money stock.' In addition, we assume that the authorities' commitment to defend the target band is perfectly credible (the imperfectly credible case will be discussed later). We first deal with the supply shock and assume that there are no shocks in the aggregate demand (i.e., p = 0). For analytical simplicity, assume that initially the supply shock is E~and the public's inflation expectations are nil (i.e., ne= 0). The initial equilibrium is at point Qo, which is the intersection of the curves AS(&,,) and AD(n' = 0). The initial output and prices are yo and Po, respectively. To make the analysis meaningful in Figure 2, we depict po inside the band. In response to a fall in the supply shock from E,, to E,, the AS(&,,) curve shifts leftward toAS(&,). If the public does not change expectations (i.e., II' = 0), intersects AD(x' = 0) at point Ql, with y and p being y , and p,, respectively. A question naturally arises in the foregoing discussion: Is the naive view that there is no change in the public's expectations valid? As indicated in Figure 1, two states may occur at the level of E,. First, with probability 1/2, E, will increase to E,. Second, with probability 1/2, E, will decrease to E ~ At . step 2 in Figure 2, if E, rises to E,,, the prices will then fall from pI to po. If E, falls to E ~ the , prices will increase from p , to the upper edge of the band F, rather than p3, because the monetary authorities will act to defend the target band. This implies that, when the shock is E,, the public's inflation expectations under a price target zone (7Z) are given by

Given -(po - P I ) > jj -PI, IT& < 0 is true. The change in expectations from xe= 0 to I ' C ~ < 0 will lead AD(xe= 0) to shift leftward to AD(n', < 0). The AS(&,)curve intersects AD(n& < 0) at point Qi, with y and p being y; and pi, respectively. Under the situation where the central bank does not set a specific target zone and lets prices adjust freely, with probability 1/2, the prices will fall from p , to po when E, increases to E~,.With probability 1/2, the prices will rise from p I to p 3 when E, decreases to E ~ Given . - p , ) = p 3 - P I , under a floating-price ( F P ) regime the public on average expects no change in prices (i.e.. 7 ~ = ; ~ [Po- p1]/2 + b3 -p1]/2 = 0). Accordingly, point Q , ,the intersection of both the AS(&,)locus and the ADCn', = 0) locus, is the equilibrium under a floating-price regime.8As is evident in Figure 2, in response to a fall in the supply shock from E~ to E,, the change in prices under a target zone (pi - Po) is less than that under a floatingprice regime @, - p,), but the change in output @; - yo) under a target zone is greater than that under a floating-price regime @, - yo). Put more precisely, an announcement of price target zones will stabilize prices but destabilize output in response to supply shock^.^ This result reveals an important policy implication: When the monetary authorities undertake a price-target-zone policy, the economy benefits from lower price variability at the expense of higher output variability.I0Our finding is also consistent with the experience of Canada and New Zealand: Inflation targets have not been able to produce a decline in inflation without a substantial decline in output and a rise in unemployment (Mishkin 1998,499).

+ ,

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The fact that aggregate supply shocks present a thornier problem for inflation targeting countries owing to larger output fluctuations is stressed by Friedman and Kuttner ( 1996). Fortunately, in practice, inflation-targeting central banks use a variety of techniques to cope with this problem. By defining well the long-run and short-run inflation goals, Bernanke et al. (1999, 291) claim that, a number of countries, including Canada and Sweden, set their initial inflation targets to take effect only with substantial delay, so as not to impose unnecessary shortrun costs in term of lost output or employment. . . . By adjusting the speed of convergence with the long-mn goal (or, nearly equivalently, the target horizon), the policy-makers can moderate the real costs of reducing inflation, and also reduce output fluctuations. . . . I i In addition, inflation targets in some countries (e.g., New Zealand and Canada) are designed to exclude the short-run effects of certain supply shocks, such as a rise in the price levels of volatile components (e.g., food, energy, and petrol) and the increase in value-added taxes. Bernanke et al. (p. 291) specifically argue that, if the authorities adequately provide explanation to the public, inflation targets with the escape clause can avoid destabilizing the economy in the short run, while still maintaining a strong commitment to the long-run price stability.'2 In terms of the demand shock, we assume that there are no shocks to the aggregate supply (i.e., E = 0). Figure 3 illustrates the consequence of a rise in the demand shock. Similar to the previous case, assume initially that p = p" and K'= 0. The initial equilibrium, where the AS locus intersects AD(p,,,n'= 0) is established at point Q,,;the initial output and prices are yo and p,,, respectively. Given that the demand shock increases from p,, to pi. the AD(p,,,V= 0) locus will shift rightward to A D ( p , , V = 0). The A S curve intersects AD(pi,n' = 0) at point Q,, with y and p being y, and p,, respectively. Following the same inference in Figure 2, given that p, is closer to the top of the band, the public would expect a decline in prices in the future (i.e., r ~ & < 0). As a consequence, the equilibrium under a price-target-zone regime occurs at point Q;, where the AS locus intersects AD(p,,n&< O), with y andp being y; and pi, respectively. The equilibrium under a floating-price regime is established at point Q,, where the A S locus intersects AD(p,,K& = O), y and p being y, and pi, respectively. It is quite clear in Figure 3 that, in response to a rise in the demand shock, the change in both output and prices under a target zone is less than that under a floating-price regime. Thus, a price target zone will stabilize both output and prices."

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AN ALTERNATIVE RANDOM SHOCK

It is useful to consider how our results are related to the random-walk assumption. We take a mean-reverting shock as an e~amp1e.l~ Assume that the normal level of the supply shock is equal to its initial level E,,. A mean-reverting process indicates that eventually the mean of E should converge to its normal level E,,. In order to meet this requirement, at any step, the supply shock that deviates from E,, will move up and down with different probability. In Figure 4, on the one hand, at step 2, E , will move up to E,,, with probability greater than 112 (say, for exam374

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FIGURE 3 The Stabilizing Effect of Inflation Targeting: A Demand Shock

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Po

A D ( p 0 , n e= 0 )

ple, 2/3), and will move down to E~ with probability less than 112 (say, 1/3). Therefore, the mean of E at E , is 2~0/3 + E J ~ ,which is greater than E,, and hence the mean of E at E, has a tendency to converge to E~). On the other hand, at step 2, E, will move up to E,, with probability less than 1/2 (say, 1/3), and will move down to E,, with probability greater than 1/2 (say, 2/3). The mean of E at E, thus is &,I3 + 2&,/3, which is less than E,, and hence the mean of E at E* has a tendency to converge to E,. We now use Figure 5 to address what would happen if E is a mean-reverting shock. The initial state in Figure 5 is the same as that in Figure 2: AS(&,) intersects AD(W = 0) at point Q,. y and p being yo and po, respectively. In response to a fall in the supply shock from E" to E , , theAS(&,) curve shifts leftward toAS(&,). Based on the description in Figure 4, E, will increase to E" with probability 2/3, and E , will decrease to E~ with probability 1/3. As expressed in Figure 5 , under the situation where the monetary authorities stand ready to defend the target band, the prices will fall from p , to po, if E, rises to E, and will increase from p , to the upper edge of the band jj (rather than p 3 ), if E , falls to E ~This . implies that, when the shock is E , , under a price-target-zone regime, the public's inflation expectations with a mean-reverting shock are given by
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FIGURE 4 The Random Walk Representation of Mean-Reverting Process

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Step 1

Step 2

Step 3

...

Given -(po- p , ) > - P I , n& < 0 is true. Under the situation where the central bank does not set a specific target zone and lets prices adjust freely, with probability 2/3, the prices will fall from p , to po when E, increases to E,. At the same time, with probability 1/3, the prices will rise from pI to p3 when E, decreases to E ~With . -(po - p , ) = p 3 -pI, the public thus expects a fall in inflation, that is,

Moreover, given p3 - p , > - p , , we can infer n& < A&, < 0, and hence in Figure 5 the AD(x& < 0) locus is located to the left of AD(.n;, < 0). Under a pricetarget-zone regime, the AS(E,) curve intersects AD(x', < 0) at point with y and p being y; and pi, respectively. Under a floating-price regime, the AS(E,) curve intersects AD(n., < 0) at point Q: y and p being y ; and p;, respectively. As is evident in Figure 5 , in response to a fall in the supply shock, the change in prices under a target zone @; - po) is less than that under a floating-price regime @;-po), but the change in output (y; - y o ) under a target zone is greater than that

a,

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FIGURE 5 The Stabilizing Effect of Inflation Targeting: A Mean-RevertingSupply Shock

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under a floating price (yy--y0).As a consequence, our conclusions of the discretestate random walk in the previous section are valid when E is a mean-reverting shock.

IMPERFECT CREDIBILITY
The problem of a central banks credibility has become a central concern of the scholarly literature on the effectiveness of policies. According to the Blinder (2000) report, among the 84 central bankers, there is an amazingly strong consensus on the importance of credibility to a central bank. However, until now we have assumed that the authorities commitment to defend target zones is perfectly credible. It is of interest to address how the authorities credibility will govern the stabilizing performance of inflation target zones. We consider a situation where the public lacks full confidence in the willingness of the authorities to defend the band. Assume that the public anticipates that the policymakers will follow their commitment with probability z (0 < z < 1). The initial state in FigintersectsA D ( V = 0) at point Q,,, with ure 6 is the same as that in Figure 2: y and p being yo and po, respectively. In response to a fall in the supply shock
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FIGURE 6 The Stabilizing Effect of Inflation Targeting and Imperfect Credibility

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Y; Y; Y I

Yo

from E, to E,, the AS(&,) curve shifts leftward to AS(&,).The AS(&,) locus intersects A D ( f l = 0) at point Ql, with y and p being yI and pI, respectively. As indicated in Figure 6, the public expects that three states may happen. First, with probability 112, the prices will fall from p , to p , when E, increases to E~ Second, with probability ( 1 1 2 ) ~ the prices will rise from pI to when E, decreases to E ~ Third, with probability (1/2)( 1 - T ) , the prices will rise from p , to p3 when decreases to E ~ Given . @ , - p , ) = p 3 -PI, the publics inflation expectations are

where ne&(lC) denotes the publics expected inflation when the authorities targeting implementation is imperfectly credible. Recall that the publics expected inflation with perfect credibility is

Then, substituting
378

+ ,- p,) = p 3 - p , into this relation, we have

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With the relationship n& < n&(IC),it is clear in Figure 6 that the AD[n&(lC) < 01 lies to the right of AD(Pn < 0). Therefore, when the authorities commitcurve intersects AD[n,(lC) < 0 1 at point ment is imperfectly credible, the Q: with y and p being y; and p;, respectively. When the authorities commitment is perfectly credible, the AS(&,) curve intersects AD(n& < 0) at point Qi, with y and p being y; and p i , respectively. As is obvious in Figure 6, in response to a fall in the supply shock, the change in prices with imperfect credibility @ ; - po) is greater than that with perfect credibility @; - po), but the change in output with imperfect credibility ( y ; - yo) is less than that with perfect credibility (y; - yo). This result reveals that the presence of imperfect credibility will increase the variability of prices and decrease the variability of output.

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CONCLUDING REMARKS
In some industrialized countries the monetary authorities have recently announced their official inflation targets and have taken a more active role in the management of prices. The motivation for such announcements is that authorities commitment will affect the publics inflation expectations and, in turn, reduce actual inflation. We present a pedagogical graphical exposition to illustrate the stabilizing effect of price target zones. Based on a textbook AD-AS apparatus, we find that the expectations of the authorities future interventions in the money market generate a mechanism to govern the agents inflation expectations. We also find that, when the economy experiences supply shocks, the announcement that the monetary authorities intend to defend a price target zone will reduce the variability of domestic prices, but raise the variability of domestic output relative to a free-price regime. However, when the economy experiences demand shocks, a price target zone tends to lower the variability of both domestic prices and output relative to a free-price regime. The graphical illustration we propose is suitable to analyze a variety of institutional arrangements or authorities interventions. The extensions include the gold points under a gold-standard system and target zones for exchange rates, nominal interest rates, and monetary aggregate^.'^
NOTES

I. For the implementation of inflation targeting, see Leiderman and Svensson (1995). Bernanke
and Mishkin (1997). and Bernanke et al. (1999). This is the reason why inflation targets serve as a nominal anchor for monetary policy. See Miller and VanHoose (1998, chapt. 8) for a detailed explanation. For simplicity, we abstract from government expenditure. Our conclusion is valid as long as the probabilities of the supply shock are distributed normally, and the mean of the supply shock E is its initial level .& ,, 6. It should be noted that, over a unit time interval, a band for inflation can be expressed in terms of the edges of prices. More specifically, given that the public knows the actual price level now and the specific band of inflation rate, they equivalently have the information of the upper and lower bounds for the next periods price level.

2. 3. 4. 5.

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7. To simplify the graphical illustration, we specify that the monetary authorities are not allowed to

8. 9.

10. I I.

12. 13.

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14. 15.

alter the money supply in the interior of the band, although some observers, for example, Bernanke et al. (1999.320). argue that the authorities often undertake intra-marginal interventions.However, our conclusions are qualitatively valid in the presence of intra-marginal interventions. It should be noted that AD(VFp= 0) coincides with A D ( V = 0). Our conclusion is parallel to Krugmans (1991) insight on exchange-rate target zones: An announcement of exchange-ratetarget zones tends to lower the variability of the exchange rate. Krugmans (1991) result now is dubbed the honeymoon effect. The similar inference is applied to a rise in the supply shock. For example, the central bankers may deal with the inflation resulting from supply shocks by setting a short-term inflation goal so that, over time, the inflation is gradually eliminated, until the long-run inflation object is once again reached. In contrast to a purely discretionary approach, such an inflation-targeting framework gives the central bank a better chance to convince the public that the effects of a supply shock will be limited to a one-time rise in the price level, rather than creating a permanent rise in the inflation rate. See Bernanke and Mishkin (1997) or Bernanke et al. (1999) for detailed illustrations. We are grateful to an anonymous referee for bringing this point to our attention. Friedman and Kuttner (1996) claim that a price-stability target makes good sense for monetary policy under some conditions but not others. A price-stability target may be optimal when the economy suffers from demand disturbances. Holding price stable, however, is not optimal in the presence of supply shocks. The Friedman and Kuttner (1996) conclusions seem to be similar to our results. It should be noted that in our analysis the stabilizing performance of price target zones stems from the fact that authorities commitment will affect the publics inflation expectations, and in turn govern actual inflation. In the interior of the band, the authorities do not alter the money supply in practice. However, in the Friedman and Kuttner analysis, the authorities always adjust the money supply to peg the target price. Obviously, the channel proposed in this article is different from that addressed by Friedman and Kuttner. An anonymous referee. to whom we are grateful, raised this question. In an international gold standard, the gold arbitragers stand ready to supply the foreign exchange at a gold-export point and demand the foreign exchange at a gold-import point. As a result, the exchange rate cannot move outside of the band bounded by the gold points. For a detailed explanation, see Chacholiades (1978, chapt. 7). REFERENCES

Bernanke, B. S., T. Laubach, F. S. Mishkin, and A. S. Posen. 1999. Inflution turgeting: Lessonsfrom the internutionul experience. Princeton, N.J.: Princeton University Press. Bernanke, B. S., and F. S. Mishkin. 1997. Inflation targeting: A new framework for monetary policy? J o u m l ofEcononiic Perspectives 1 I (Spring): 95-1 16. Blinder, A. S. 2000. Central-bank credibility: Why do we care? How do we build it? Anrericun Economic Review 90 (December): 1421-31. Chacholiades, M. 1978. Intemutionul nronetury theory and policy. New York: McGraw-Hill. Friedman, B., and K. Kuttner. 1996. A price target for U. S. monetary policy? Lessons from the experience with money growth targets. Brookings fupers on Economic Activiry 1:77-125. Krugman, P. 1991. Target zones and exchange rate dynamics. Quurterly Journul of Economics 106 (August): 669-82. Leiderman, L., and L. E. 0. Svensson. 1995. Inflution mrgets. London: CEPR. Miller, R. L., and D. VanHoose. 1998. Mocmecononiics: Theories. policies. und intemtionul upplications. Cincinnati: South-Western. Mishkin, F. S. 1998. The econoniics of money, bunking undfimnciul nrarkets. 5th ed. New York: Addison-Wesley.

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