RDP 1999-08: Inflation Targeting and Output Stabilisation 1. Introduction

Inflation targeting has been adopted as the framework for monetary policy in a number of countries over the past decade. The adoption of a monetary policy framework that focuses explicitly on inflation has reflected the growing realisation that the major contribution that monetary policy can make to economic growth and welfare in the long run is the maintenance of a low and stable inflation rate. This realisation has been supported by the empirical evidence on the detrimental effects of higher inflation on economic growth, and also by the evidence of the absence of a negatively sloped long-run trade-off between inflation and growth.

However, some have criticised inflation targeting for its perceived focus on inflation as the only goal for monetary policy, to the exclusion of other goals, most notably output (see for example, Friedman and Kuttner (1996)). While the empirical evidence may suggest the absence of a negative long-run trade-off, there is ample evidence of a negative short-run trade-off. The short-run trade-off, often represented by the short-run Phillips curve, implies a trade-off between output and inflation variability. An exclusive focus on returning inflation to the target rate as quickly as possible may come at the expense of creating excessive volatility in output.

Given that the ultimate goal of policy is not inflation stabilisation per se but rather welfare maximisation, is inflation targeting too narrow a framework for monetary policy? Does inflation targeting pay sufficient attention to output stabilisation, as, for example, a nominal income targeting framework might? This paper considers these questions drawing on the existing theoretical and empirical literature.

The next section presents a simple model to illustrate the interaction between output and inflation. The following section considers output and inflation variability in more detail. Section 4 summarises some empirical evidence on the trade-off between output and inflation variability, focusing particularly on the Australian evidence. Section 5 discusses how the design of the inflation-targeting framework can allow more scope for output stabilisation and can address some of the issues involved in the variability trade-off. Section 6 illustrates these issues by considering the actions of monetary policy in three recent episodes in Australia. Section 7 concludes.

This paper argues that inflation targeting does take output stabilisation into account. In general, the inflation-targeting framework has sufficient flexibility to allow for the short-run trade-off between output and inflation. The extent to which it does so in part reflects some design features of the inflation-targeting framework, such as targeting bands and the policy horizon, that have been adopted in practice in the inflation-targeting countries. Medium-term price stability can be maintained while still allowing some degree of short-run inflation variability, thus providing scope for lower output variability.