Inflation Targeting Under Imperfect Knowledge

50 Pages Posted: 28 Jul 2006

See all articles by Athanasios Orphanides

Athanasios Orphanides

Massachusetts Institute of Technology (MIT) - Sloan School of Management; Asia School of Business

John C. Williams

Federal Reserve Bank of New York

Multiple version iconThere are 2 versions of this paper

Date Written: May 2006

Abstract

A central tenet of inflation targeting is that establishing and maintaining well-anchored inflation expectations are essential. In this paper, we reexamine the role of key elements of the inflation targeting framework towards this end, in the context of an economy where economic agents have an imperfect understanding of the macroeconomic landscape within which the public forms expectations and policymakers must formulate and implement monetary policy. Using an estimated model of the U.S. economy, we show that monetary policy rules that would perform well under the assumption of rational expectations can perform very poorly when we introduce imperfect knowledge. We then examine the performance of an easily implemented policy rule that incorporates three key characteristics of inflation targeting: transparency, commitment to maintaining price stability, and close monitoring of inflation expectations, and find that all three play an important role in assuring its success. Our analysis suggests that simple difference rules in the spirit of Knut Wicksell excel at tethering inflation expectations to the central bank's goal and in so doing achieve superior stabilization of inflation and economic activity in an environment of imperfect knowledge.

Keywords: Learning, natural rate of interest, natural rate of unemployment, rational expectations, monetary policy rules, uncertainty, bond prices

JEL Classification: D83, D84, E52, E58

Suggested Citation

Orphanides, Athanasios and Williams, John C., Inflation Targeting Under Imperfect Knowledge (May 2006). CEPR Discussion Paper No. 5664, Available at SSRN: https://ssrn.com/abstract=921081

Athanasios Orphanides (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

HOME PAGE: http://mitsloan.mit.edu/faculty/detail.php?in_spseqno=54058

Asia School of Business ( email )

Jalan Kuching, Kuala Lumpur, Wilayah Persekutuan K
Kuala Lumpur, MA
Malaysia

John C. Williams

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States