By contrast, the analysis of this paper is based on an estimated empirical model with
a shifting inflation target. Time variation of the inflation target incorporates exogenous
and endogenous sources, and is not limited to a small number of policy regimes. Additional
contributions of the paper include a model specification with both permanent and transitory
policy shocks, explicit estimation of the implicit actual and perceived inflation target series,
and dynamic analysis linking private sector perceptions of target shocks to the behavior of
long-term interest rates.
The next section introduces the empirical model with a time-varying inflation target,
asymmetric information, and learning. Section 3 discusses estimation procedures.
Estimation results are presented for both the time-varying target model and a model
that assumes the inflation target is constant and credible. Kalman filter estimates of
the perceived inflation target and the inflation target obtained from the time-varying
model are presented. Section 4 compares the dynamic responses of the two systems to
transitory structural shocks and explores responses to target and expectations shocks in
the time-varying target model. Three important results are obtained. First, in general,
responses in the time-varying target model tend to be smaller and less persistent than those
in the constant target model. Second, in contrast to the transitory effects obtained with
the constant-target model, aggregate supply shocks have permanent effects on inflation and
nominal interest rates in the time-varying-target model as a consequence of partial policy
accommodation of supply shocks. Third, the “price puzzle” in the response of inflation to
a transitory policy shock disappears in the model with a time-varying target and learning.
Section 5 explores the role of the speed of learning in the time-varying target model. The
speed of learning is shown to influence the volatility and persistence of responses to policy
shocks. As the speed of learning increases, i.e., with an improvement in credibility, real costs
associated with the transition to a new inflation regime are smaller. However, faster learning
also implies greater volatility in inflation target perceptions in response to transitory policy