Working paper/research report

Publication year: 2012

URL: https://hdl.handle.net/10419/73138

Title of series: MAGKS Joint discussion paper series in economics

Number in series: 2012, 35

Abstract: 

In this paper we systematically evaluate how central banks respond to inflation deviations from target. We present a stylized New Keynesian model in which agents' inflation expectations are sensitive to inflation deviations from target. To (re-)establish credibility, optimal monetary policy under discretion is shown to set higher interest rates today if average inflation exceeded the target in the past. Moreover, policy responds non-linearly to past inflation gaps. This is reflected in an additional term in the central bank's optimal instrument rule, which we refer to as the credibility loss. Augmenting a standard Taylor (1993) rule with the latter term, we provide empirical evidence for the interest rate response for a sample of nine IT or quasi-IT economies. We find that past deviations from the inflation target are feeding back into the reaction function of seven central banks and that this influence is economically meaningful. A deteroriation in credibility forces central bankers to undertake larger interest rate steps (ceteris paribus).

Harvard Citation style: Neuenkirch, M. and Tillmann, P. (2012) Inflation targeting, credibility and non-linear Taylor rules. (MAGKS Joint discussion paper series in economics, 2012, 35). Marburg: Philipps-University Marburg. https://hdl.handle.net/10419/73138

APA Citation style: Neuenkirch, M., & Tillmann, P. (2012). Inflation targeting, credibility and non-linear Taylor rules. (MAGKS Joint discussion paper series in economics, 2012, 35). Philipps-University Marburg. https://hdl.handle.net/10419/73138