Top

Journal of Economic Interaction and Coordination

Published in:

17-11-2016 | Regular Article

Band or point inflation targeting? An experimental approach

Authors: Camille Cornand, Cheick Kader M’baye

Published in: Journal of Economic Interaction and Coordination | Issue 2/2018

Activate our intelligent search to find suitable subject content or patents.

search-config

AI-assisted search

Off

Abstract

We conduct laboratory experiments with human subjects to test the rationale of adopting a band versus point inflation targeting regime. Within the standard New Keynesian model, we evaluate the macroeconomic performances of both regimes according to the strength of shocks affecting the economy. We find that when the economy faces small uncorrelated shocks, the level of inflation as well as its volatility are significantly lower in a band targeting regime, while the output gap and interest rate levels and volatility are significantly lower in a point targeting regime with tolerance bands. However, when the economy faces large uncorrelated shocks, choosing the suitable inflation targeting regime is irrelevant because both regimes lead to comparable performances. These findings stand in contrast to those of the literature and question the relevance of clarifying a mid-point target within the bands, especially in emerging market economies more inclined to large and frequent shocks.

previous article A survey of network-based analysis and systemic risk measurement

next article Capability-based governance patterns over the product life-cycle: an agent-based model

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Online-Abonnement

Mit Springer Professional "Wirtschaft+Technik" erhalten Sie Zugriff auf:

über 102.000 Bücher
über 537 Zeitschriften

aus folgenden Fachgebieten:

Automobil + Motoren
Bauwesen + Immobilien
Business IT + Informatik
Elektrotechnik + Elektronik
Energie + Nachhaltigkeit
Finance + Banking
Management + Führung
Marketing + Vertrieb
Maschinenbau + Werkstoffe
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Springer Professional "Wirtschaft"

Online-Abonnement

Mit Springer Professional "Wirtschaft" erhalten Sie Zugriff auf:

über 67.000 Bücher
über 340 Zeitschriften

aus folgenden Fachgebieten:

Bauwesen + Immobilien
Business IT + Informatik
Finance + Banking
Management + Führung
Marketing + Vertrieb
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Available only for authorised users

See e.g. Fraga et al. (2003), Levin et al. (2004), Roger and Stone (2005), Lin and Ye (2009), and Roger (2009).

For instance, the Governor of the Reserve Bank of New Zealand is subject to resignation as soon as actual inflation deviates from the band target without convincing explanations.

In the same vein, Meyer (2002) and Mishkin (2008) argue that a point target is more appropriate in that it provides a more precise anchor for inflation expectations of agents, and a more specific target to be achieved by monetary authorities. When a country chooses to target a band for inflation, the implications in terms of costs when inflation deviates from the band will arise, and in the absence of any explicit focal point within the band, questions arise about where the monetary authorities would like inflation to be stabilized. When the movements of actual inflation within the band do not matter for the monetary authorities, the latter become too flexible and this entails a high variability of inflation, which can be detrimental. In addition, a band target can undermine the credibility of the central bank, once actual inflation deviates from the band.

See Hommes (2011) for an overview on LtFE.

Indeed, as argued by Calvo and Mishkin (2003) and Fraga et al. (2003), emerging market economies suffer from instability due to large and frequent external shocks.

Note that the choice of this simplified model is in line with the experimental macro literature, as e.g. Pfajfar and Zakelj (2014) and Cornand and M’baye (2016). However, it is worth mentioning that the non-microfounded NK model presented in Eqs. (1)–(3) uses average expectations instead of aggregated expectations as in e.g. Gali (2009). Kurz (2012) shows that these two do not necessarily coincide even in a linearized model, which implies that monetary policy and aggregate fluctuations might be altered.

As in Assenza et al. (2013), the fundamental shocks considered here are i.i.d. white noises. Instead, Pfajfar and Zakelj (2013, 2014) assume an AR(1) noise process.

In contrast to Kryvtsov and Petersen (2013) or Arifovic and Petersen (2015), we ask for inflation expectations only (and not for output gap expectations). As that of Pfajfar and Zakelj (2013, 2014) and Assenza et al. (2013), our set-up presents the drawback to be less exhaustive in this respect but has the advantage to ask subjects for an easier task.

Both survey papers (e.g. Pesaran and Weale 2006; Andolfatto et al. 2008; Lanne et al. 2009; Coibion and Gorodnichenko 2015) and the LtFE literature (e.g. Hommes et al. 2005; Assenza et al. 2013; Pfajfar and Zakelj 2014; Petersen 2014) show that subjects’ inflation expectations fail to be captured by rational expectations, but instead are well described by simple strategies, such as naive expectations.

Our experimental framework is close to Pfajfar and Zakelj (2013, 2014) and Assenza et al. (2013), as we use the same model and the results come from agents’ inflation expectations. However, our study differs from theirs in at least two respects. First, while these papers focus on the interplay between agents’ inflation expectations formation process and monetary policy, our analysis focuses more precisely on the role of the announced point and band inflation target on agents’ inflation expectations and on macroeconomic outcomes. Second, the reaction function of the central bank is also different: Pfajfar and Zakelj (2013, 2014) and Assenza et al. (2013) assume that the central bank only cares about inflation stabilization, while we more realistically assume that the central bank additionally takes into account (but with less weight) output gap stabilization.

The same Taylor rule (Eq. 3) was used both in simulations and in the experiment. In the experiment, both treatments (band and point) were equivalent except that the announcement was different: announcing a point target with margin error of ±1% or an explicit band (between 4 and 6% of inflation). As we wanted to analyze the pure communication effect of announcing a band or a point target, we strictly refer to this equation in each treatment. Moreover, in an uncertain environment, the central bank, which announces a band target, knows the numerical mid-point of the band it wishes to reach but does not clearly announce it to the public. As emphasized by Demertzis and Viegi (2009), every central bank has in practice a numerical inflation target that it wishes to reach irrespective of whether it announces it clearly to the public or not. Hence, the standard Taylor rule is convenient for both treatments.

The program was written using z-Tree (Fischbacher 2007).

“Appendix 5” provides a translation from French to English of instructions. “Appendix 6” shows some examples of the screens.

Note that initialization to a value that is below the target (which stands in contrast to the implementation of IT in various countries, especially emerging economies, when inflation was above the subsequent target) may impact the results of the experiment. As will become clear in Sect. 4, especially in the small uncorrelated shock environment, the realized inflation is always below the target.

This rule represents only one example. One could do the same exercise with a rule including the target and adaptive or trend-extrapolative inflation expectations.

Simulations with lower values of q yield very similar trends.

The latter rule is extreme in the sense that it does not account for the announcement of the band target. It therefore simply provides an idea on the direction of outcomes in comparison to a situation where the point target is communicated.

The steady state is \({\bar{y}}=0.1\), \({\bar{\pi }}=4.8\), \({\bar{i}}=4.8\), which are close to target values.

This section partly relies on individual expectation formation as described in “Appendix 7” to explain macroeconomic results.

Non-parametric tests are usually used to deal with experimental data as the size of samples is generally very small. We use two non-parametric tests in our analysis: the Mann–Whitney–Wilcoxon procedure which is used to test whether two samples come from the same population against an alternative hypothesis, especially that a particular population tends to have larger values than the other, and the Siegel–Tukey’s test which is used to assess whether there is a difference in terms of variances between series. The null hypothesis is that there is no difference between series of interest.

“Appendix 4” provides figures showing the evolution of inflation and average inflation expectations for each session of each treatment.

Note that realized inflation is always below the target, which may be due to the fact that initialization was below the target.

To control for the convenience of using non-parametric tests in our analysis, we perform the Jarque–Bera (JB) test for normality of our macroeconomic series. All draws exhibit non-normal distributions (JB p value \(=0.000\)) except for the output gap series of both band and point targeting in the large shocks environment. However, we obtain the same conclusion as for the Mann–Whitney–Wilcoxon test when applying the mean t test pairwise comparison on these output gap series (p value of the t test \(=0.9963\) and p value of the MWW \(=0.9958\)). We also median-adjust our data in order to check for the robustness of the Siegel–Tukey’s test conclusion: our results are unaffected.

See also “Appendix 2” for the descriptive statistics of all treatments.

By contrast, this observation is, for instance, well captured in the standard heuristic switching model proposed by Brock and Hommes (1998).

The descriptive statistics provided in “Appendix 2” go in the same direction.

In this respect, our study complements the analysis of Orphanides and Williams (2007) who propose a model that accounts for economic agents’ imperfect understanding of the macroeconomic landscape and estimate it. They highlight that monetary policy rules which perform well when agents form rational expectations may not be appropriate when agents rely on adaptive learning. In the context of imperfections in expectation formation, they show that central bank communication, and in particular the announcement of an explicit quantitative inflation target, can improve macroeconomic performance. In contrast to Orphanides and Williams, focusing on a situation of large uncorrelated shocks, in which the anchoring effect of inflation expectations is strong in comparison to a situation of small uncorrelated shocks (Sect. 4.1), we do not find a significant impact of the announcement of an explicit inflation target.

We drop the first 10 periods of the experiment out of our regression samples. Indeed, as in Assenza et al. (2013), we assume that subjects need to have first a learning step before completely forming their forecasting rules.

Note that in Table 2, the shares of each treatment do not add up to 100%. This is explained by the fact that subjects switch between different rules during the experiment as supported by the literature. See e.g. Assenza et al. (2013), Pfajfar and Zakelj (2013, 2014), and Cornand and M’baye (2016).

Andolfatto D, Hendryand S, Moran K (2008) Are inflation expectations rational? J Monet Econ 55:406–422CrossRef

Arifovic J, Petersen L (2015) Stabilizing expectations at the zero lower bound: experimental evidence. Technical report. Available at SSRN 2735651

Assenza T, Heemeijer P, Hommes C, Massaro D (2013) Individual expectations and aggregate macro behavior. Technical report, Tinbergen Institute Discussion Papers 13-016/II

Barro R, Gordon D (1983) A positive theory of monetary policy in a natural rate model. J Polit Econ 91:589–610CrossRef

Bernanke B, Laubach T, Mishkin F, Posen, A (1999) Inflation targeting: lessons from the international experience. Technical report, Princeton University Press

Bomfin A, Rudebusch G (2000) Opportunistic and deliberate disinflation under imperfect credibility. J Money Credit Bank 32:707–721CrossRef

Brock W, Hommes C (1998) Heterogeneous beliefs and routes to chaos in a simple asset pricing model. J Econ Dyn Control 22(8):1235–1274CrossRef

Calvo G, Mishkin F (2003) The mirage of exchange rate regimes for emerging market countries. J Econ Perspect 17(4):99–118CrossRef

Clarida R, Gali J, Gertler M (2000) Monetary policy rules and macroeconomic stability: evidence and some theory. Q J Econ 115(1):147–180CrossRef

Coibion O, Gorodnichenko Y (2015) Information rigidity and the expectations formation process: a simple framework and new facts. Am Econ Rev 105:2644–2678CrossRef

Cornand C, M’baye CK (2016) Does inflation targeting matter? an experimental investigation. Macroecon Dyn. doi:10.1017/S1365100516000250

Demertzis M, Viegi N (2009) Inflation targeting: a framework for communication. BE J Macroecon 9:1–32

Fischbacher U (2007) z-tree: Zurich toolbox for ready-made economic experiments. Exp Econ 10(2):171–178CrossRef

Fraga A, Goldfajn I, Minella A (2003) Inflation targeting in emerging market economies. Technical report, NBER Working Paper No. 10019

Gali J (2009) Monetary policy, inflation, and the business cycle: an introduction to the new keynesian framework. Princeton University Press, Princeton

Hammond G (2012) State of the art of inflation targeting, chapter in: handbooks. Number 29. Centre for Central Banking Studies, Bank of England

Heenan G, Peter M, Roger S (2006) Implementing inflation targeting: institutional arrangements, target design, and communications. Technical report, IMF Working Paper/06/278

Hommes C (2011) The heterogeneous expectations hypothesis: some evidence from the lab. J Econ Dyn Control 35(1):1–24

Hommes C, Sonnemans J, Tuinstra J, Velden HVD (2005) Coordination of expectations in asset pricing experiments. Rev Financ Stud 18(3):955–980CrossRef

Kryvtsov O, Petersen L (2013) Expectations and monetary policy: experimental evidence. Technical report, Department of Economics, Simon Fraser University, Discussion Papers series dp13-09

Kurz M (2012) A new keynesian model with diverse beliefs. Technical report. Available at SSRN 1938821

Lanne M, Luoma A, Luoto J (2009) A nave sticky information model of households inflation expectations. J Econ Dyn Control 33:1332–1344CrossRef

Levin A, Natalucci F, Piger J (2004) The macroeconomic effects of inflation targeting. Fed Reserve Bank St. Louis Rev 86(4):51–80

Lin S, Ye H (2009) Does inflation targeting make a difference in developing countries? J Dev Econ 89:118–123CrossRef

Meyer L (2002) Inflation targets and inflation targeting. N Am J Econ Finance 13:147–162CrossRef

Mishkin F (2008) Whither federal reserve communications. Technical report, Remarks at the Peterson Institute for International Economics, Washington DC

Mishkin F, Westelius N (2008) Inflation band targeting and optimal inflation contracts. J Money Credit Bank 40(4):557–582CrossRef

Mokhtarzadeh F, Petersen L (2016) Central bank communication and expectations. Technical report, Working Paper Department of Economics, Simon Fraser University

Orphanides A, Williams JC (2007) Inflation targeting under imperfect knowledge, volume Vol. XI, chapter. In: Mishkin F, Schmidt-Hebbel K (eds) Monetary policy under inflation targeting. Banco central de Chile, Santiago

Pesaran H, Weale M (2006) Survey expectations. In: Elliott G, Granger C, Timmermann A (eds) Handbook of economic forecasting, chap 14, vol 1. Elsevier, North Holland, pp 715–776

Petersen L (2014) Forecast error information and heterogeneous expectations in learning-to-forecast macroeconomic experiments. Expe Macroecon 17:109–137CrossRef

Pfajfar D, Zakelj B (2013) Inflation expectations and monetary policy design: evidence from the laboratory. Technical report, Tilburg University

Pfajfar D, Zakelj B (2014) Experimental evidence on inflation expectation formation. J Econ Dyn Control 44:147–168CrossRef

Roger S (2009) Inflation targeting at 20: achievements and challenges. Technical report, IMF working paper 09/236, International Monetary Fund

Roger S Stone M (2005) On target? The international experience with achieving inflation targets. Technical report, IMF working paper No. 05/163, International Monetary Fund

Title: Band or point inflation targeting? An experimental approach
Authors: Camille Cornand
Cheick Kader M’baye
Publication date: 17-11-2016
Publisher: Springer Berlin Heidelberg
Published in: Journal of Economic Interaction and Coordination / Issue 2/2018
Print ISSN: 1860-711X
Electronic ISSN: 1860-7128
DOI: https://doi.org/10.1007/s11403-016-0183-y

Springer Professional

Abstract

Please log in to get access to your license.

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Springer Professional "Wirtschaft"

Other articles of this Issue 2/2018

“Speculative Influence Network” during financial bubbles: application to Chinese stock markets

Competitive moment matching of a New-Keynesian and an Old-Keynesian model

Capability-based governance patterns over the product life-cycle: an agent-based model

Correction to: Heterogeneity in social values and capital accumulation in a changing world

Long-run consequences of debt

Mathematical models describing the effects of different tax evasion behaviors