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The paper examines inflation targeting in a small open economy with forward-looking aggregate supply and demand with microfoundations, and with stylized realistic lags in the different monetary-policy transmission channels. The paper compares strict and flexible targeting of CPI and domestic inflation, and inflation-targeting reaction functions and the Taylor rule. Flexible CPI-inflation targeting does not limit the variability of CPI inflation but also the variability of the output gap and the real exchange rate. Negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap, and induce similar monetary policy responses.

During the 1990s, several countries (New Zealand, Canada, UK, Sweden, Finland, Australia and Spain) have shifted to a new monetary policy regime, inflation targeting. This regime is characterized by (1) an explicit quantitative inflation target, either an interval or a point target, where the center of the interval or the point target currently varies across countries from 1.5 to 2.5 percent per year, (2) an operating procedure that can be described as `inflation-forecast targeting', namely the use of an internal conditional inflation forecast as an intermediate target variable, and (3) a high degree of transparency and accountability.1 The operating procedure can be described as inflation-forecast targeting in the following sense: The central bank's internal conditional inflation forecast (conditional upon current information, a specific instrument path, the bank's structural model(s), and judgemental adjustments of model forecasts with the use of extra-model information) is used as an intermediate target variable. An instrument path is selected which results in a conditional inflation forecast in line with a(n explicit or implicit) target for the inflation forecast (for instance, at a particular horizon, the forecast for inflation equals, or is sufficiently close to, the quantitative inflation target). This instrument path then constitutes the basis for the current instrument setting. Inflation-targeting regimes are also characterized by a high degree of transparency and accountability. Inflation-targeting central banks regularly issue `Inflation Reports', explaining and motivating their policy to the general public. In New Zealand, the Reserve Bank Governor's performance is being evaluated, and his job is potentially at risk, if inflation exceeds 3 percent per year or falls below 0. In the UK, the Chancellor of Exchequer recently announced that, if inflation deviates more than 1 percentage point from the inflation target of 2.5 percent, the Governor of the Bank of England shall explain in an open letter why the divergence has occurred and what steps the Bank will take to deal with it. As argued in Svensson (1998a), inflation targeting can be interpreted as the announcement and assignment of a relatively specific loss function to be minimized by the central bank. The operating procedure, inflation-forecast targeting, can be interpreted as a way of ensuring that first-order conditions for a minimum of the loss function are approximately fulfilled. The high degree of transparency and accountability, especially the published Inflation Reports, can be interpreted as a way for outside observers of verifying that the first-order conditions are fulfilled. As shown in Faust and Svensson (1997), more transparency makes the central bank's reputation more sensitive to the bank's actions and increases the cost of deviation from the announced policy. Thus, the high degree of transparency increases the incentives for the central bank to minimize the assigned loss function. This means that inflation targeting is a strong commitment to an optimizing policy relative to the assigned loss function (it is argued in Svensson (1998a) that it is a stronger commitment than any other monetary policy regime so far). Therefore, inflation targeting can be very well modeled as the minimization of a given loss function, as will be done in this paper. The above operating procedure implies that all relevant information is used for conducting monetary policy. It also implies that there is no explicit instrument rule, that is, the current instrument setting is not a prescribed explicit function of current information. Nevertheless, the procedure results in an endogenous reaction function, which expresses the instrument as a function of the relevant information. The reaction function will, in general, not be a Taylor-type rule (where a Taylor-type rule denotes a reaction function rule that is a linear function of current inflation and the output gap only)2 except in the special case when current inflation and output are sufficient statistics for the state of the economy. Typically, it will depend on much more information; indeed, on anything affecting the central bank's conditional inflation forecast. Especially for an open economy, the reaction function will also depend on foreign variables, for instance foreign inflation and output and interest rates, since these have domestic effects.3 All real-world inflation-targeting economies are quite open economies with free capital mobility, where shocks originating in the rest of the world are important, and where the exchange rate plays a prominent role in the transmission mechanism of monetary policy. Nevertheless, most previous formal work on inflation targeting deals with closed economies (including my own in Svensson (1997a) and Svensson (1997b)).4 The main purpose of this paper is to extend the formal analysis of inflation targeting to a small open economy where the exchange rate and the shocks from the rest of the world are important for conducting monetary policy. Another purpose is to incorporate recent advances in the modelling of forward-looking aggregate supply and demand. Most of the previous work on inflation targeting has used simple representations of aggregate supply and demand which more or less disregard forward-looking aspects.5 Including the exchange rate in the discussion of inflation targeting has several important consequences. First, the exchange rate allows additional channels for the transmission of monetary policy. In a closed economy, standard transmission channels include an aggregate demand channel and an expectations channel. With the aggregate demand channel, monetary policy affects aggregate demand, with a lag, via its effect on the short real interest rate (and possibly on the availability of credit). Aggregate demand then affects inflation, with another lag, via an aggregate supply equation (a Phillips curve). The expectations channel allows monetary policy to affect inflation expectations which, in turn, affect inflation, with a lag, via wage and price setting behavior. In an open economy, the real exchange rate will affect the relative price between domestic and foreign goods, which, in turn, will affect both domestic and foreign demand for domestic goods, and hence contribute to the aggregate-demand channel for the transmission of monetary policy. There is also a direct exchange rate channel for the transmission of monetary policy to inflation, in that the exchange rate affects domestic currency prices of imported final goods, which enter the consumer price index (CPI) and hence CPI inflation. Typically, the lag of this direct exchange rate channel is considered to be shorter than that of the aggregate demand channel. Hence, by inducing exchange rate movements, monetary policy can affect CPI inflation with a shorter lag. Finally, there is an additional exchange rate channel to inflation: The exchange rate will affect the domestic currency prices of imported intermediate inputs. Eventually, it will also affect nominal wages via the effect of the CPI on wage-setting. In both cases, it will affect the cost of domestically produced goods, and hence domestic inflation (inflation in the prices of domestically produced goods). Second, as an asset price, the exchange rate is inherently a forward-looking and expectations-determined variable. This contributes to making forward-looking behavior and the role of expectations essential in monetary policy. Third, some foreign disturbances will be transmitted through the exchange rate, for instance, changes in foreign inflation, foreign interest rates and foreign investors' foreign-exchange risk premium. Disturbances to foreign demand for domestic goods will directly affect aggregate demand for domestic goods. Thus, this paper will attempt to construct a small open-economy model, with particular emphasis on the exchange rate channels in monetary policy, in order to model the effect on the equilibrium of domestic and foreign disturbances and the appropriate monetary-policy response to these disturbances under inflation targeting. Several particular issues will be discussed. First, all inflation-targeting countries have chosen to target CPI inflation, or some measure of underlying inflation that excludes some components from the CPI, for instance, costs of credit services. None of them has chosen only to target domestic inflation (either inflation in the domestic component of the CPI, or GDP inflation). One difference between CPI inflation and domestic inflation is that the direct exchange rate channel is more prominent in the former case. I will try to characterize the differences between these two targeting cases. Second, under strict inflation targeting (when stabilizing inflation around the inflation target is the only objective for monetary policy; the terminology follows Svensson (1997b) the direct exchange rate channel offers a potentially effective inflation stabilization at a relatively short horizon. Such ambitious inflation targeting may require considerable activism in monetary policy (activism in the sense of frequent adjustments of the monetary policy instrument), with the possibility of considerable variability in macro variables other than inflation. In contrast, flexible inflation targeting (when there are additional objectives for monetary policy, for instance output stabilization), may allow less activism and possibly less variability in macro variables other than inflation. Consequently, I will attempt to characterize the differences between strict and flexible inflation targeting. Third, I will try to characterize the appropriate monetary policy response to domestic and foreign shocks, and especially the appropriate response to exchange rate movements, under different forms of inflation targeting. In this context, the Taylor rule offers a focal point for discussing reaction functions, and is, in practice, increasingly used as a reference point in practical monetary policy discussions. Consequently, I will compare the reaction functions arising under inflation targeting in an open economy to the Taylor rule, particularly in order to judge what guidance the Taylor rule provides in a small open economy. The results of my study indicate that strict CPI-inflation targeting indeed implies a vigorous use of the direct exchange rate channel for stabilizing CPI inflation at a short horizon. This results in considerable variability of the real exchange rate and other variables. In contrast, flexible CPI-inflation targeting ends up stabilizing CPI-inflation at a longer horizon, and thereby also stabilizes real exchange rates and other variables to a significant extent. In comparison with the Taylor rule, the reaction functions under inflation targeting in an open economy responds to more information than does the Taylor rule. In particular, the reaction function for CPI-inflation targeting deviates substantially from the Taylor rule, with significant direct responses to foreign disturbances. With regard to the monetary-policy response to different shocks, counter to conventional wisdom, the optimal responses to positive demand shocks and negative supply shocks are very similar. Section 2presents the model, Section 3compares the different cases of targeting, and Section 4presents the conclusions. The working paper version of this paper, Svensson (1998b) contains further technical details.

I have presented a relatively simple model of a small open economy, with some microfoundations, and with stylized, reasonably realistic relative lags for the different channels for the transmission of monetary policy: The direct exchange rate channel to the CPI has the shortest lag (for simplicity set to a zero lag), the aggregate demand channel's effect on the output gap has an intermediate lag (set to one period), and the aggregate demand and expectations channels on domestic inflation have the longest lag (set to two periods). Within this model, I have examined the properties of strict vs flexible inflation targeting, and domestic vs CPI-inflation targeting, especially relating them to the properties of the Taylor rule. This examination shows that flexible inflation targeting, effectively compared to strict inflation targeting, induces less variability in variables other than inflation, by effectively targeting inflation at a longer horizon. Especially, strict CPI-inflation targeting involves using the direct exchange rate channel to stabilize CPI inflation at a short horizon, which induces considerable real exchange rate variability. In contrast, flexible CPI-inflation targeting, compared to both strict CPI-inflation targeting and flexible domestic-inflation targeting, results in considerable stabilization of the real exchange rate. In a situation with weight on stabilization of both inflation and real variables, CPI-inflation targeting appears as an attractive alternative. The implicit reaction functions arising under domestic-inflation and CPI-inflation targeting differ from the Taylor rule. CPI-inflation targeting deviates conspicuously from the Taylor rule, due to its implicit concern about real exchange rate depreciation. Such concern makes the response to foreign disturbances and variables important, whereas the Taylor rule excludes any direct response to these. Already in a closed economy, the Taylor rule uses only part of the information available; in an open economy it uses an even a smaller part. On the other hand, the Taylor rule does not result in exceptionally large variability in any variable, except possibly the real exchange rate; consequently it appears rather robust. The model I use distinguishes between demand and supply shocks. There are two kinds of supply shocks: cost-push shocks and productivity shocks. The response to a positive demand shock and a negative productivity shock are very similar (except that the response of the real exchange rate is more persistent for the latter). This similarity may appear surprising, given the conventional wisdom that supply shocks cause a conflict between inflation and output stabilization. There are several reasons for the similarity. First, both shocks increase the output gap, and the output gap is the major determinant of domestic inflation. Second, under flexible inflation targeting, the central bank wants to stabilize the variability of the output gap, rather than of output itself, as specified in the loss function I have used. For a productivity shock, there is little conflict between stabilizing the output gap and stabilizing output. For a supply shock, there is a considerable conflict between output-gap stabilization and output stabilization. Then there is little conflict between inflation stabilization and output-gap stabilization, but considerable conflict between inflation stabilization and output stabilization. Thus, since output-gap stabilization rather than output stabilization is one of the goals, there is little difference between positive demand and negative productivity shocks, except that the persistence of the shocks may be quite different. Instead, the conflict between inflation stabilization and output-gap stabilization arises for cost–push supply shocks, rather than for productivity supply shocks. 24 There are some obvious limitations to the analysis that may indicate suitable directions for future work. First, as emphasized above, there is no calibration and/or estimation of the parameters in the current version; the only criterion applied is that they must not be a priori unreasonable. As a consequence, the numerical results are only indicative. Second, although some microfoundations are provided for the aggregate supply and demand functions, as shown in Svensson (1998b), there is some arbitrariness in the assumptions of partial adjustment and the addition of disturbance terms. At the cost of introducing additional forward-looking variables, it is relatively straightforward to implement the ideas of polynomial costs of adjustment of Pesaran (1991) and Tinsley (1993). Also, only sticky prices have been explicitly modelled; with sticky wages, as noted by, for instance, Andersen (1997), the dynamics can be quite different. Third, the model is linear with a quadratic loss function. Nonnegative nominal interest rates is one source of nonlinearity, nonlinear Phillips curves is another. However, any nonlinearity would prevent the use of the convenient and powerful algorithm for the optimal linear regulator with forward-looking variables. Fourth, the particular relative lag structure I have used has been imposed on the model; there are obvious alternatives that may be worth pursuing.25 Fifth, the disturbances and the state variables are assumed to be observable to both the central bank and the private sector. In the real world, disturbances and the state variables are not directly observable, and the private sector and the central bank have to solve complicated signal-extraction problems. Some of the implications for inflation targeting of imperfectly observed states and disturbances are examined in Svensson and Woodford (2000). Sixth, there is no uncertainty in the model about the central bank's loss function and the inflation target is perfectly credible. Some new results on the consequences of imperfect credibility and less than full transparency of monetary policy are provided by Faust and Svensson (1997). Seventh, although it would be very desirable to test the model's predictions empirically, the short periods of inflation targeting in the relevant countries probably imply that several additional years of data are necessary for any serious empirical testing.