No 38. Inflation Target Instability and Interest Rates

by Stefan Mellin¤
March, 1997

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. The marginal effect from less instrument 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 Classification numbers

E42, E52, E58