Monetary Policy and Inflation

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Inflation Targets, Credibility, and Persistence
In a Simple Sticky-Price Framework
Jeremy Rudd
Federal Reserve Board
Karl Whelan
Central Bank of Ireland
July 23, 2003
This paper presents a re-formulated version of a canonical sticky-price model that has been extended to account for variations over time in the central bank's inflation tar- get. We derive a closed-form solution for the model, and analyze its properties under various parameter values. The model is used to explore topics relating to the e ects of disinflationary monetary policies and inflation persistence. In particular, we employ the model to illustrate and assess the critique that standard sticky-price models generate counterfactual predictions for the e ects of monetary policy. Corresponding author. Mailing address: Mail Stop 80, 20th and C Streets NW, Washington, DC 20551. E-mail:

E-mail: We thank Gregory Mankiw and Olivier Blanchard for useful dis- cussions on several of the topics considered here. The views expressed in this paper are our own, and do not necessarily reflect the views of the Board of Governors, the sta of the Federal Reserve System, or the Central Bank of Ireland.

1 Introduction
An important trend in macroeconomic research in recent years involves the increased use of optimization-based sticky-price models to analyze how monetary policy a ects the econ- omy and how optimal policy should be designed. Much of this analysis employs a simple baseline model that features a \new-Keynesian" Phillips curve to characterize inflation, an \expectational IS curve" to determine output growth, and a policy rule that describes how the central bank sets short-term interest rates; representative examples of studies that use this framework include Clarida, Gal, and Gertler (1999), McCallum (2001), and Wood- ford (2003).

One limitation of existing work in this area is that applications of the baseline model have typically been restricted to contexts in which the central bank maintains a xed infla- tion target, with particular attention being paid to the e ects of the type of monetary policy \shock" that is usually analyzed in the empirical VAR literature (namely, a temporary de- viation from a stable policy rule). In this paper, we present a re-formulated version of the baseline sticky-price model that has been extended to account for variations over time in the central bank's inflation target. We derive a fully speci ed closed-form solution for the model in which output and inflation are related both to policy shocks (as usually de ned) and to expected future changes in the inflation target. The model provides a simple but flexible framework for understanding a number of issues that have previously been dealt with using a range of di erent speci cations. In particular, the model sheds light on some important existing critiques regarding the general ability of sticky-price models to capture the e ects of disinflationary monetary policies.

One such critique that we consider stems from Laurence Ball's (1994) well-known ex- ample of a sticky-price economy in which an announcement of a gradual reduction in the rate of growth of the money supply results in a boom in output. This has commonly been seen as an important counterfactual prediction of these models in light of the large observed costs of disinflation; moreover, Ball's result appears at odds with the position of Woodford (2003) and others that these models adequately capture the e ect of a monetary tightening on output. We use our framework to demonstrate how these apparently con- tradictory results can be reconciled by noting that they reflect the e ects of two di erent types of shocks in our model. Speci cally, in the more general framework that we derive here, Ball's example of a gradual disinflation that is achieved through a deceleration in the money supply is equivalent to an example where the central bank's target...
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