Scandinavian Working Papers in Economics

SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

No 92: Inflation Rules with Consistent Escape Clauses

Annika Alexius
Additional contact information
Annika Alexius: Department of Economics, Postal: Stockholm School of Economics, Box 6501, 113 83 Stockholm, Sweden.

Abstract: Simple inflation targets may be supplemented with an escape clause to be evoked in case the economy is hit by a major supply shock. In this paper, consistent solutions to the Flood and Isard (1990) escape clause model are derived in the spirit of Lohmann (1990), She showed that Flood and Isard's assumption of symmetric boundary values of shocks, outside of which the zero inflation rule should be broken, is inconsistent if the output or employment target differs from the natural rate. This is quantitatively important since the optimal boundary values in the consistent model are highly asymmetric. The effects of unemployment persistence on the optimal escape clause are also investigated in a two period version of the model. In the second period, monetary policy should respond more often to supply shocks if unemployment is persistent. The first period effect may be of either sign.

Keywords: Escape clauses; monetary policy

JEL-codes: E52

35 pages, January 1996

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