Optimal Inflation Targeting:
Further Developments of Inflation Targeting
Lars E.O. Svensson
CEPR and NBER
First draft: May 2005
This version: August 2006
Frederic, and Klaus Schmidt-Hebbel (eds.) (2007), Monetary Policy under
Inflation Targeting, Banco Central de Chile, Santiago, Chile, 187-225.
The introduction of inflation targeting has led to major progress in practical monetary policy. Nevertheless, inflation-targeting central banks can make substantial additional progress by being more specific, systematic, and transparent about their operational objectives (in the form of using an explicit intertemporal loss function), their forecasts (in the form of deciding on optimal projections of the instrument rate and the target variables), and their communication (in the form of announcing optimal projections of the instrument rate and target variables). Furthermore, progress can be made by incorporating central-bank judgment and model uncertainty in a systematic way in the forecasting and decision process. In particular, incorporating model uncertainty allows the central bank to do more general “distribution forecast targeting” rather than the more restrictive “mean forecast targeting” under the assumption of approximate certainty equivalence.
JEL Classification: E42, E52, E58
Keywords: Forecasts, optimal monetary policy.
(A preliminary and incomplete version of this paper paper was
previously circulated under the title “Further Developments of Inflation