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Inflation Band Targeting and Optimal Inflation Contracts

Authors


  • We would like to thank Roc Armenter, Lars Svensson, Carl Walsh, Michael Woodford, John Williams, and participants in seminars at Columbia University, Duke University, the Board of Governors of the Federal Reserve System, the New York Area Workshop on Monetary Policy, the International Monetary Fund, and the National Bureau of Economic Research. This paper was completed before Frederic Mishkin became a member of the Board of Governors of the Federal Reserve System. He is currently on leave from the Graduate School of Business, Columbia University and the National Bureau of Economic Research. Any views expressed in this paper are those of the authors only and not those of the Board of Governors of the Federal Reserve System, the Federal Reserve System, Columbia University, the City University of New York, or the National Bureau of Economic Research.

Abstract

In this paper we provide a theoretical treatment of how inflation target ranges cope with the time-inconsistency problem arising from incentives for the monetary policymaker to exploit the short-run trade-off between employment and inflation to pursue short-run employment objectives, as in a Barro-Gordon (1983) model. Inflation band targets are able to achieve many of the benefits that arise under practically less attractive solutions such as the conservative central banker and optimal inflation contracts. Our theoretical model also shows how an inflation targeting range should be set and how it should respond to changes in the nature of shocks to the economy.

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