Inflexibility Of Inflation Targeting Revisited: Modeling The "Anchoring" Effect

Opponents of inflation targeting have argued that a commitment to a numerical inflation target reduces policy’s stabilization flexibility – increasing output volatility under supply shocks. Using a novel game theoretic approach our paper demonstrates that this claim may fail to account for the ‘anchoring’ effect of explicit targets on expectations and wages. Under a credible long-term inflation target and costly acquiring information/wage resetting the public may find it optimal to ‘look-through’ shocks. This makes policymaker’s short-term interest rate instrument more effective in output stabilization giving it greater leverage over the real rate. As a consequence, the variability trade-off is improved, i.e. volatility of both inflation and output is reduced in equilibrium. Our analysis thus adds another dimension to the ‘rule vs. discretion debate’ by showing that a long-run rule may be compatible with (and in fact enhance the effectiveness of) short-run discretion. We conclude by showing that our results are consistent with several empirical findings of the literature.