Scandinavian Working Papers in Economics

Research Papers in Economics,
Stockholm University, Department of Economics

No 1997:4: Inflation Target Instability and Interest Rates

Stefan Mellin
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Stefan Mellin: Dept. of Economics, Stockholm University, Postal: Department of Economics, Stockholm University, S-106 91 Stockholm, Sweden

Abstract: The implementation of explicit quantitative inflation targets elucidates the assessment of credibility of future monetary policy. Here the explicit inflation target is time-varying and stochastic with asymmetric information. It is shown that central bank independence promotes lower inflation but not at the cost of increased output variability. Marked political instability and instrument dependence are detrimental to credibility, and impede monetary policy with unchanged long term nominal interest rates. The marginal effect from less independence on interest rate volatility is increasing in political instability. Strategic delegation of an optimal inflation target with a monetary reform eliminates the inflation bias. Empirical evidence substantiates the predictions when confronted with cross-country OECD data.

Keywords: inflation target; credibility; political instability; independence

JEL-codes: E52; E58

31 pages, June 2, 1998

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