Why is Inflation Targeting Successful?: Analysis of Inflation Target Transparency

Although there are many studies that empirically investigate the impact of Inflation Targeting (IT) on several aspects of the economy, the mechanisms through which IT improves the economic conditions are not studied extensively. A theoretical study is needed to present the dynamics of IT and uncover the reasons behind the success of IT. In this paper, we theoretically investigate the mechanisms through which IT effects the expectations of the public and achieve desired levels of inflation, inflation uncertainty and credibility. The study considers two mechanisms through which IT achieves its goals: (1) improvement in the credibility of the Central Bank (CB) (2) improvement in the ability of the central bank to alter the expectations of the public. To analyze these mechanisms, we construct and solve a model of asymmetric information and learning between the CB and the public. The source of the asymmetric information is the time-varying inflation targets of the CB. This paper theoretically investigates the effect of IT on the information dynamics between the Central Bank (CB) and the public. The paper introduces time-varying implicit inflation targets of the CB as the potential source of asymmetric information. Then, the model shows that IT central banks attain the desired outcomes because IT eliminates the asymmetric information about the implicit inflation targets of the CB and the frictions caused by that asymmetric information. Following the empirical findings of Ireland (2007) and Leigh (2008), we construct a model of asymmetric information and learning where the CB has an implicit inflation target and that target is unknown to the public. The model features two agents, the Central Bank (CB) and a representative private-sector agent. The information structure is hierarchical since the CB is assumed to possess private information that the private-sector agent tries to deduce by observing the CB’s actions. Hierarchical information structure is modeled as in Townsend (1983). The information structure consists of two steps: • The CB determines its inflation target of time t and uses a simple Taylor rule to determine the interest rate. . The CB follows an AR(1) rule for the inflation target as in Gurkaynak et al. (2005). (This target is announced to the public in the inflation targeting case). • The representative private-sector agent observes the interest rate and the inflation target.(in the inflation targeting case) and revises her inflation and output expectations. To analyze these mechanisms, we construct and solve a model of asymmetric information and learning between the CB and the public. The source of the asymmetric information is the time-varying inflation targets of the CB. The model depends on unobserved-components modelling with state-space representations. The model is solved using the Kalman filtering algorithm. The results present that IT countries attain the desired outcomes because IT eliminates the asymmetric information and the frictions caused by that asymmetric information. As a result, we propose and theoretically show that in non-IT countries the private agents are uncertain about the implicit inflation target of the CB and they construct their expectations about the target by following the actions of the CB. That learning dynamics increases the uncertainty and the level of inflation significantly. IT eliminates that uncertainty about the inflation target since the target is announced and becomes public information. The announcement of a credible target anchors inflation expectations as empirically shown by Gurkaynak et al. (2010) and lower levels of inflation and inflation uncertainty are achieved as a result. There are three main results of this paper. First, inflation and output expectations of the public are significantly affected by the inflation target under the case of IT. In other words, we theoretically present the mechanism through which IT anchors inflation and output expectations. Second, in the discretionary CB case, the private sector agent uses a filtered estimate of the inflation target of the CB to form her expectations which increases the variance (stability) of inflation expectations of the public. Finally, credibility of the CB is significantly affected by the target under the IT case. The CB can improve its credibility by announcing a credible target.