Lars E.O. Svensson
Princeton University and Stockholm University; CEPR and NBER
First version: May 1999
Version 3.1: January 2003
Journal of Economic Literature 41 (2003) 426-477.
Abstract
Most recent research on monetary-policy rules is restricted to consider a commitment to simple instrument rules, where the central-bank instrument is a simple function of available information about the economy, like the Taylor rule. However, a commitment to a simple instrument rule appears inadequate as a description of current goal-directed and forward-looking monetary policy, especially inflation targeting. The latter can to a large extent instead be seen as inflation-forecast targeting, setting the instrument so that the corresponding conditional inflation forecast is consistent with the inflation target. It is argued, both from a descriptive and a prescriptive perspective, that inflation targeting is better understood as a commitment to a targeting rule, either a general targeting rule in the form of clear objectives for monetary policy or a specific targeting rule in the form of a condition for (the forecasts of) the target variables, essentially the equality of the marginal rates of transformation and the marginal rates of substitution between the target variables. Targeting rules allow the use of judgment and extra-model information, are more robust and easier to verify than optimal instrument rules, but they can nevertheless bring the economy close to the socially optimal equilibrium. These ideas are illustrated with the help of simple examples. Some recent defense of commitment to simple instrument rules and criticism of forward-looking monetary policy and targeting rules by McCallum, Nelson and Woodford are also addressed. In the concluding section, robust and optimal rules for monetary policy are suggested.
This revision now includes a discussion of the proposal that instrument rules, like the Taylor rule, are not meant to be followed mechanically but to be mere “guidelines” for monetary policy. The proposal is found to be too vague to be
operational.
JEL Classification: E42, E52, E58
Keywords: Inflation targeting, forecast targeting