Wednesday, March 13, 2013

Optimal deviations from inflation targeting

When a central bank adopts a monetary policy target, such as a targeted inflation rate, should it absolutely adhere to this goal, or are deviations from the goal tolerated? This is not necessarily a rehash of the "rules versus discretion" question, as it is a question about the formulation of the policy rule. In other words, is it OK for a central bank that has a specific inflation target to use a rule that deviates from the target under specific circumstances?

Barbara Annicchiarico and Lorenza Rossi say this is OK, and these circumstances do not need to be extraordinary. The reason here is the often neglected impact of economic shocks, in particular technology shocks, on the growth potential of economy. Without the endogenous growth mechanism, the optimal policy of the central bank is to stick to the target. With it, it can deviate because the dynamics of the economy and the intertemporal trade-offs make it optimal to give a little bit of slack now to be in better shape in the future.

This reminds me about the silly debate about the ineffectiveness of central banks when inflation is below target when unemployment is still high. It is all about the dynamics of adjustment of the economy after a shock. Economic variable do not go back to long-run equilibrium in one shot, it takes time and they can be off long-run values even in equilibrium and under optimal policy.


Tom Holden said...
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Tom Holden said...

Can an AK-style model really tell us anything sensible about optimal policy? The model would feature increasing growth rates over time in the presence of population growth; is it really so surprising that the planner wants to induce extra labour supply in response to shocks? Even if you fix the strong scale effect through some knife-edge assumption, then you're left with a model in which standard business cycle shocks lead to large permanent changes in real output, whereas in reality US real GDP is near stationary.

You have to work a lot harder to get an endogenous growth model to give sensible cyclical dynamics, and once you've done this the policy implications might be quite different. I've started to address these issues in my own work.