Inflation targeting is a monetary-policy strategy that is characterized by an announced numerical inflation target, an implementation of monetary policy that gives a major role to an inflation forecast and has been called forecast targeting, and a high degree of transparency and accountability. It was introduced in New Zealand in 1990, has been very successful in terms of stabilizing both inflation and the real economy, and has, as of 2010, been adopted by about 25 industrialized and emerging-market economies. The chapter discusses the history, macroeconomic effects, theory, practice, and future of inflation targeting.

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Indeed, one of the first lessons one learns from studying a variety of hypothetical models is that the problem of economic stabilization is, even in principle, an extremely intricate one, and that a much more thorough investigation of both theoretical principles and empirical relationships would be needed before detailed policy recommendations could be justified. ” A. W. Phillips (1957, reprinted 1965, p. 677)

An independent central bank can manage its balance sheet and its capital so as to commit itself to a depreciation of its currency and an exchange-rate peg. This way, the central bank can implement the optimal escape from a liquidity trap, which involves a commitment to higher future inflation. This commitment mechanism works even though, realistically, the central bank cannot commit itself to a particular future money supply. It supports the feasibility of Svensson’s Foolproof Way to escape from a liquidity trap.

The Eurosystem should modify its definition of price stability to a symmetric and unambiguous inflation target, at the level of 1.5 or 2% per year. It should abandon its two-pillar strategy and adopt the superior international-best-practice strategy of flexible inflation targeting.

The development of the Riksbank’s transparency and communication since its independence in 1999 is reviewed. The Riksbank’s record on the management of market expectations of future policy rates after the publication of policy-rate paths in February 2007 is examined, with a focus on the exceptional deviations of market expectations from published policy-rate paths since April 2009. The possible explanations discussed include differing views of future economic developments, communication challenges associated with very low interest rates and perhaps exaggerated lower-bound problems. The consequences of such large deviations of market expectations may be severe and potentially imply a much more restrictive monetary policy than intended. Whether the Riksbank’s transparency and communication are sufficient for effective accountability and evaluation is assessed, and it is shown that tools are available for the effective real-time evaluation of the Riksbank’s policy. Some conclusions and suggestions for possible improvements in the Riksbank’s transparency and communication are offered. JEL Classification: E52, E58

By the end of the Great Moderation, over two dozen central banks were formal inflation targeters, and others, such as the Federal Reserve, the European Central Bank, and the Swiss National Bank behaved essentially as inflation targeters even though they were resistant to identifying themselves as such. However, the past three years have seen central banks faced with new challenges, and these have raised questions about the future of inflation targeting as a framework for the conduct of monetary policy. I consider three suggested modifications to this policy framework: incorporating additional goals among a central bank’s objectives; raising the average target for inflation; and switching to price level targeting.

In 2004 all publications will carry a motif taken from the €100 banknote. This paper can be downloaded without charge from

In 2004 all publications will carry a motif taken from the €100 banknote. This paper can be downloaded without charge from

We examine the impact of fiscal policy interventions in an environment where the short term nominal interest rate is at the zero bound. In the basic New Keynesian model in which the monetary authority operates a Taylor rule, globally multiple equilibria arise, some of which display all the features of a liquidity trap. A loss in confidence can set the economy on a deflationary path that eventually prevents the monetary authority from adjusting the interest rate and can lead to potentially very large output drops. Contrary to a line of recent papers, we find that demand stimulating policies become less effective in a liquidity trap than in normal circumstances. The key reason is that demand stimulus leads agents to believe that things are even worse than they thought. In contrast, supply side policies, such as cuts in labor income taxes, lead to relative optimism and become more powerful.