Chapter

Limits to Inflation Targeting

Christopher A. Sims

in The Inflation-Targeting Debate

Published by University of Chicago Press

Published in print February 2005 | ISBN: 9780226044712
Published online February 2013 | e-ISBN: 9780226044736 | DOI: http://dx.doi.org/10.7208/chicago/9780226044736.003.0008
Limits to Inflation Targeting

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Inflation targeting requires central banks not only to explain how their current actions relate to their view of the future course of the economy, but also to be explicit about how precisely they can control inflation. However, there are bounds, set by fiscal policy broadly conceived, on the central bank's control over inflation. It may lose control of a deflation. As a theoretical possibility, the lack of a credible fiscal policy may open the door to equilibria in which accelerating inflation leads to demonetization of the economy, even when policies are also consistent with stable equilibria. This chapter first models both bonds and money in order to discuss policy in terms of an interest rate rule. It then introduces a foreign currency-denominated asset, in order to consider a central bank with reserves only and no access to a backup taxing power. The model retains the “inflationary demonetization” equilibria, which can be avoided only with tax backing or reserves. Finally, the chapter discusses the pros and cons of inflation targeting and ways of improving it.

Keywords: inflation targeting; fiscal policy; deflation; inflationary demonetization; reserves; tax backing; interest rate rule; bonds; money; central banks

Chapter.  11106 words.  Illustrated.

Subjects: Financial Markets

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