Scandinavian Working Papers in Economics

Working Paper Series,
Sveriges Riksbank (Central Bank of Sweden)

No 141: Inflation Targeting and the Dynamics of the Transmission Mechanism

Hans Dillén ()
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Hans Dillén: Monetary Policy Department, Central Bank of Sweden, Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden

Abstract: This paper derives closed-form expressions for optimal monetary policy rules when the central bank can influence inflation directly with a one-period lag as well as a two-period lagged effect via the output gap. It turns out that even a modest one-period inflation effect from monetary policy actions has substantial implications for monetary policy that also seem to be a step towards increased realism. For instance, in models where the central bank only can affect inflation with a two-period lag via the output gap, policy becomes more aggressive and the output gap exhibits a tendency to switch sign frequently. This unrealistic oscillating feature can be avoided by allowing the central bank to influence inflation with a one-period lag. The model also illustrates that the nature of empirical (or reduced-form) Phillips curves may reflect monetary policy and the observation that the Phillips curve in recent years has become flatter can in this model be explained by a more counter-cyclical monetary policy.

Keywords: Inflation targeting; optimal monetary policy; the transmission mechanism

JEL-codes: E52; E58

17 pages, First version: September 1, 2002. Revised: July 1, 2004.

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