Inflation Targeting in Small Open Economies (Updated 11/8/2015)
Inflation targeting is a central banking policy that tries to meet some preset targets for the annual inflation rate. The benchmark for inflation targeting is usually some price index of a basket of consumer goods, such as CPI. “The approach is characterized … by the announcement of official target ranges for the inflation rate at one or more horizons, and by the explicit acknowledgement that low and stable inflation is the overriding goal of monetary policy. Other important features of inflation include increased communication with the public about the plans and objective of the monetary policymakers, and, in many cases, increased accountability of the central bank for attaining those objectives…”(Bernanke and Mishkin 1997)
Countries that adopt inflation targeting:
New Zealand, Chile, Canada, Israel, Sweden, Finland, Australia, Czech Republic, Brazil, Colombia, Mexico, South Africa, Norway, Peru, Philippines, Poland, Guatemala, Indonesia, Romania, Armenia, Turkey, Ghana, Serbia, the United States.
Mishkin and Schmidt-Hebbel (2007) finds that inflation targeting helps countries achieve lower inflation in long run, have smaller inflation response to oil-price and exchange-rate shocks, strengthen monetary policy independence, improve monetary efficiency, and obtain inflation outcomes closer to target levels. However, the effects are not the same across all countries that adopt inflation targeting. The paper finds that industrial-country inflation targeters generally dominates the performance of emerging-economy inflation targeters.
Rudebusch and Svensson (1998) models the interest rate as an exogenous variable under the perfect control of the Fed. Changes in interest rate affect the deviation of real output from potential, which in turn affects inflation through an output-based Phillips curve. Control rules (Instrument rules such as Taylor rule) are evaluated in terms of their expected loss, which is a function of the variances of the inflation, potential GDP, and the interest rate. The two rules that perform well in the paper are the Taylor rule and a constant-interest-rate inflation forecast rule. However, it also implies that the Taylor rule might not work very well in small open economies.
According to Svensson (1996), in the simplest models, under strict inflation targeting, policy is set based on a two-period ahead forecast of inflation so as to move towards the target within the minimum control lag. However, under flexible inflation targeting the inflation forecast horizon is longer than the minimum control lag, depending on the nature of the central bank’s preferences. These preferences are reflected in an objective function that penalizes deviation of inflation from target, and possibly deviations of output from potential, and may also reflect some preference for interest-rate smoothing. Svensson (1998) and Ball (1998) extend models of inflation targeting to an open-economy setting.
Ball (1998) includes the indirect effect of exchange rates on inflation via the output gap, as well as the direct effect of the exchange rate on the domestic price of imported intermediate inputs. The direct effect of the exchange rate on the domestic price of imported intermediate outputs. The direct effect implies that the central bank can target inflation with a one-period lag. Thus movements in the exchange rate have strong implications for the setting of interest rate. Ball shows that an economy subject to exchange rate fluctuations will be forced to make frequent adjustments to the interest rate in order to achieve a strict inflation target. This will generate volatility in output which may be unacceptable to the monetary authority. To avoid excessive variability in the economy, Ball suggests targeting a refined measure of inflation which abstracts from the direct, but temporary effects of changes in the exchange rate.
Svensson (1998) presents an open-economy model where goods are either imported, or domestically produced. He assumes that the economy is small in the market for imported goods, but not in the world market for its own output. This justifies the distinction between CPI-inflation targeting, and targeting inflation of domestically produced goods. Strict CPI-inflation targeting relies on the direct exchange rate channel to stabilize inflation at a short horizon, and thus introduces substantial fluctuation in other variables. For this reason, Svensson recommends flexible CPI-inflation targeting which stabilizes inflation and output at a longer horizon.
I think
(Updated 10/18/2015)
In 2001, Norway became one of the few countries in the world to adopt inflation targeting. The new regulation clearly states the target of monetary policy would be “…annual consumer price inflation of approximately 2.5% over time…” by Norges Bank, Norway’s central bank.
Reference:
Ben Bernanke and Frederic Mishkin, “Inflation Targeting: A New Framework for Monetary Policy?,” Journal of Economic Perspectives 11, no. 2 (1997): 97–116.
Frederic Mishkin and Klaus Schmidt-Hebbel, “Does Inflation Targeting Make a Difference?,” Working Paper (Czech National Bank, Research Department, December 2006), http://econpapers.repec.org/paper/cnbwpaper/2006_2f13.htm.
(Updated 10/10/2015)
In 2001, Norway became one of the few countries in the world to adopt inflation targeting. The new regulation clearly states the target of monetary policy would be “…annual consumer price inflation of approximately 2.5% over time…” by Norges Bank, Norway’s central bank. In this paper I want to investigate the challenges of inflation targeting in Norway and the outcome of the monetary policy.
The biggest challenge of inflation targeting is how to design the optimal monetary policy. Instead of trying to increase growth or reduce unemployment, the central bank should aim at maintaining price stability in short-run. Svensson (1997) shows that flexible inflation targeting is the same as explicit output stabilization. Alesina et al. (2001) shows that stabilising the inflation rate around the target can also stablize output around the capacity level.
We also need to consider the politics-bank relationship in Norway.
- The Norweigian government has direct control over central bank.
- The Executive Board of central bank has candidates nominated by political parties in Norway (Svensson 2001).
Alesina, A., O. Blanchard, J. Galí, F. Giavazzi and H. Uhlig (2001): Defining a macroeconomic framework for the Ruro Area, Monitoring the European Central Bank 3, CEPR
Ball, L. (1998), “Policy Rules for Open Economies”, Reserve Bank of Australia Research Discussion Paper No. 9806.
Gjedrem, Svein (2001): Monetary policy and the krone exchange rate, ACI Norge – The Financial Markets Association, Oslo, 26 August 2004.
Norges Bank (1999-2001): Inflation Report.
Svensson, Lars E.O. (1996): ”Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets”, European Economic Review, 41, 1111-1146
Svensson, Lars E.O. (1998): “Open-economy Inflation Targeting”, Unpublished.
Svensson, Lars E.O. (2001): An independent review of the operation of monetary policy in New Zealand, mimeo, Stockholm University