Monetary Policy of Inflation Band Targeting under Uncertatinty

Abstract

Monetary policy in nowadays is focused on the role of economic agents’ anticipations on macroeconomic and it seems to be broad agreement that effect of monetary policy depends on the change in expected path of real interest rates significantly. Thus, many central banks increase their communication in the way that can anchor public’s expectation to improving the effectiveness of monetary policy. In practical, inflation-targeting central banks already issue “target criterion”, i.e., the first-order condition from optimal monetary policy. However, they may implement biased policy due to systematic biased problem which their output gap target does not consist to the desirable output gap. As a result, central banks control their projections in the way that they can make the projections precise enough to eliminate the likely level of imprecision of output target. This study assume that central bank that faces the problem of systematic biased will tries to minimize the quadratic loss function, subject to their views of transmission mechanism and also commit to control the precision of the target criterion within some credible limits. In addition, central bank imposes band on the target criterion in order to controlling the precision of target criterion. In order to describe this procedure in theoretical monetary policy model, this study employs the idea of “optimal inflation contract” and inflation deviation (amount of gap between inflation rate and its target value) must depend on economic conditions. Thus, if bandwidth becomes narrower, it implies that the inflation gap will expect to be smaller. The more likely smaller inflation gap is the more likely lesser response of inflation with output gap. This study found that band-targeting is neither rigid as “conservative weight” nor costly as “inflation contract”. Therefore, it can bring the second-best equilibrium to society (as inflation contract) at best, or it can bring third-best equilibrium to society (as conservative weight) at least. However, the tolerance band-targeting mechanism seems to have some non-robustness character across different central bank’s views of transmission. In order promote the robustness of tolerance band-targeting mechanism we need to: First, increase the number of member in monetary policy committee who has great distaste in losing policy credibility. Second, create institutional arrangement for policy deliberation that emphasis the value of establishing policy credibility, such as Reserve Bank of New Zealand Act of 1989. Finally, increase the degree of transparency in monetary policy which is the explicit communication about the reasoning behind decisions, i.e., the target criterion. However, there are rich number of future economic events and central bank need to evaluate the new event from their prior evaluation. Therefore, the target criterion needs to have some degree of explicit formula and prescribes the possible actions in any events, such as, announcing the target criterion and specify boundaries.