### Inflation Targeting and the Taylor Rule

The Taylor rule and inflation targeting are important elements of recent discussions of interest rate rules and the goals of monetary policy. For those of you unfamiliar with these terms, the Taylor rule is discussed momentarily. Inflation targeting is described by Ben Bernanke and Frederic Mishkin:

Ben S. Bernanke; Frederic S. Mishkin, The Journal of Economic Perspectives, Vol. 11, No. 2. (Spring, 1997), pp. 97-116 (JSTOR link): … This approach is characterized … by the announcement of official target ranges for the inflation rate at one or more horizons, and by the explicit acknowledgment that low and stable inflation is the overriding goal of monetary policy. Other important features of inflation targeting include increased communication with the public about the plans and objectives of the monetary policymakers, and, in many cases, increased accountability of the central bank for attaining those objectives…

Let’s start with what I believe is a source of miscommunication in discussions of monetary policy goals. In the traditional Phillips curve formulation of the policy problem there is a tradeoff between inflation and unemployment in the short-run. Thus, an interest rate rule that has the federal funds rate as a function of the deviations of inflation and output from their target values must choose weights, b and 1-b, in the Taylor rule:

where ff is the federal funds rate, y is output, p is inflation (not the price level), b is between 0 and 1, and * indicates the target value. The term v picks up the monetary shock. The politics of this is often expressed as Democrats and the lower income workers being more concerned with output and unemployment and thus wanting a high value of b, and those concerned with inflation, generally identified as the wealthy and the right, wanting a high value for 1-b.

But there is another view of this model that avoids these politics because it does not involve choosing one goal over the other. If we start with a general equilibrium model with wage and price stickiness, the type of model presented here, and we ask what type of policy rule (appropriately linearized) maximizes household welfare, the answer looks a lot like a traditional Taylor rule. And, surprisingly, the optimal federal funds rate rule, the one that maximizes welfare (i.e. stabilizes the welfare relevant concept of the output gap), puts a large weight on the deviation of inflation from target relative to the weight on the deviation of output from its target. That is why the goal of output and employment stability expressed as maximizing household welfare, and the economic security that comes with it, is consistent with the a policy rule that places a lot of weight on inflation.

There are many other issues regarding the Taylor rule. The Taylor rule presented above is far too simple to serve as an adequate representation of the kinds of policy rules used in theoretical and econometric investigations, and I plan to cover some of this in future posts. Some of the issues I’d like to address are interest rate smoothing (adding lagged interest rate values to the Taylor rule, see Woodford, ch. 6), how to measure real activity and core inflation to set policy, whether to use actual deviations or expected future deviations in the policy rule, whether to use real-time or revised data, and other issues.

Posted by Mark Thoma on Monday, June 20, 2005 at 12:42 AM in Economics, Monetary Policy |
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