Journal Article

Inflation targeting during asset and commodity price booms

Nicoletta Batini and Eugen Tereanu

in Oxford Review of Economic Policy

Published on behalf of The Oxford Review of Economic Policy Ltd

Volume 26, issue 1, pages 15-35
Published in print January 2010 | ISSN: 0266-903X
Published online January 2010 | e-ISSN: 1460-2121 | DOI: http://dx.doi.org/10.1093/oxrep/grp032
Inflation targeting during asset and commodity price booms

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The recent global economic crisis originated in the midst of a commodity price boom that had triggered sharp increases in inflation in many world countries. The crisis also came in the context of a rally in asset prices and large domestic imbalances in the United States. This paper uses a small open-economy dynamic stochastic general equilibrum (DSGE) model to design the correct monetary policy response to a protracted supply shock, and examines how that response would change when many become credit constrained—like in a credit crunch—and when spending of those who can still borrow becomes very sensitive to the interest rates because of overleveraging. Using a version of the model with Kalman learning, the paper also evaluates the implications of a loss of target credibility, showing how rules must be adjusted when the authorities’ commitment to the inflation target has been eroded. The appropriate response to future evolutions of the price of oil, including to large downward corrections from the current level, is also evaluated.

Keywords: inflation targeting; oil prices; asset prices; supply shock; bubble; optimal horizon; monetary policy rules; E37; E52; E58

Journal Article.  10032 words.  Illustrated.

Subjects: Economic Development and Growth ; Public Economics ; Political Economy ; Public Policy

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