INFLATION TARGETING WITH IMPERFECT INFORMATION*

• Date: 01 February 2016
• DOI: http://doi.org/10.1111/iere.12155
• Author: Rafael Santos,Tiago Berriel,Aloisio Araujo
• Published date: 01 February 2016

INTERNATIONAL ECONOMIC REVIEW

Vol. 57, No. 1, February 2016

INFLATION TARGETING WITH IMPERFECT INFORMATION∗

BYALOISIO ARAUJO,TIAGO BERRIEL,AND RAFAEL SANTOS 1

EPGE/FGV and IMPA, Brazil; PUC-Rio, Brazil; FGV and Central Bank of Brazil, Brazil

In a global games setup with imperfect commitment technology, we show that low targets—the ones close to

the optimal inflation under perfect commitment—are unattainable, leading to a trade-off between low and credible

targets. Moreover, since noisy public information helps to coordinate expectations around the announced target, our

article supports unconventional policy prescriptions. First, weaker countries need to impose higher targets. Second, less

transparency helps to make the announced target credible and then reduces the optimally announced target. Results are

based on a general central bank loss function encompassing models traditionally used to discuss central bank decisions.

1. INTRODUCTION

The announcement of inflation targets has been a trend in central banking over the last

20 years. In 1990, New Zealand was the only country under a formal inflation targeting regime.

In 2006, the list of inflation targeters was long and diverse and included countries such as

Australia, Brazil, Canada, Czech Republic, Iceland, Hungary, Mexico, Norway, Korea, Poland,

Sweden, Switzerland, UK, and Turkey.2Proponents of inflation targeting argue that it anchors

expectations, leads to less costly disinflations, and is less subject to confidence crises than

alternative regimes, such as exchange rate pegs.3

In this article, we study the limits of target coordination. More specifically, we analyze the

conditions for a low target to be preferred over a higher one. We define high targets as those

close to the discretionary inflation equilibrium, opposed to a low target that is close to the

inflation level under perfect commitment equilibrium. Results are based on a general central

bank loss function and are presented in two information setups: (i) a full-information model

following a standard benchmark in the literature, and (ii) a global game model where private

agents have imperfect information about central bank commitment technology, introducing an

information disadvantage by agents with respect to the central bank’s preferences or policy

parameters. The second approach has been viewed as a step toward a more realistic model.4

In a full-information model, we show that a target can be chosen that is high enough to lead

to a unique equilibrium, whereas a low target may lead to multiple equilibria, depending on

the central bank loss function. Thus, we highlight the restrictions of low targets to be delivered,

limiting the arguments of the proponents of always setting very low inflation targets.

In a global games setup, where each agent receives one private noisy signal and one public

noisy signal about the central bank commitment technology, the above results remain: Lower

targets require stronger conditions over the loss function in order to assure a unique equilibrium.

∗Manuscript received April 2012; revised June 2014.

1We are grateful to Manuel Amador, Ricardo Cavalcanti, Guilhermo Calvo, Harold Cole, Luciana Fiorini, Stephen

Morris, Ricardo Reis, Nelson Souza, and two anonymous referees. The views expressed in this article do not necessarily

reflect those of the Central Bank of Brazil. Araujo thanks FAPERJ and CNPQ for financial support. Please address

correspondence to: Aloisio Araujo, Estrada Dona Castorina, 110, 22460-320 Rio de Janeiro, Brazil. Phone: 55-21-3799-

5833. Fax: 55-21-2529-5129. E-mail: aloisio.araujo@fgv.br.

2For more details, see Carvalho and Goncalves (2008).

3See Kumhof et al. (2007).

4See examples that explore the same type of information disadvantage in Orphanides and Williams (2007), Milani

(2007), and Cogley et al. (2014).

255

C

(2016) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

256 ARAUJO,BERRIEL,AND SANTOS

Australia

Brazil

Canada

Chile

Colombia

Korea

Iceland

Israel

Mexico

Norway

New Zeland

Peru

UK Sweden

Switzerland

0

2

4

6

8

10

12

14

02468

Transparency Index as of 2005

Dincer, Eichengreen, NBER (2007)

Inflaon Target Upper Limit as of 2005

World Economic Outlook 4, IMF

FIGURE 1

TRANSPARENCY VS.ANNOUNCED TARGET

Moreover, we show that for a given central bank loss function, a noisier public signal improves

coordination. The lowest target assuring a unique equilibrium decreases with noisier public

information. Accordingly, too much transparency represented by precise public signal increases

the expected losses from ambitious low targets.5

The intuition for limited ability to coordinate expectations around low targets goes as follows:

Low targets for inflation are far from the discretionary inflation level, fueling the central bank’s

temptation to renege later, even when reputation costs are considered. Agents take this into

consideration when forming their expectations about the subsequent behavior of the central

bank. Agents’ doubts about the target reinforce the central bank’s temptation to renege, which,

in turn, reinforces doubts, and so on. This reinforcement channel reduces coordination around

the target and becomes more important when agents tend to agree with each other. This is the

case when public signaling is precise. Consequently, low targets may result in worse equilibrium

outcomes and less credible central bank policy announcements, especially under precise public

knowledge.

Positively, while making explicit the limitations of inflation targeting regimes, our model

addresses the inflation target heterogeneity across countries and years. Considering perfectly

credible policymakers, common knowledge, and homogeneous inflation costs, targets should

always and everywhere be very low. In our model, imperfect commitment technology explains

the presence of high targets for inflation. Moreover, heterogeneity in the central bank loss

functions would generate endogenous reasons for heterogeneity not only in target level but also

in the precision of the available public information. Figure 1 suggests that highly committed

central banks tend to announce lower targets and to be more transparent.6Normatively, our

results provide a word of caution against low targets announced by policymakers neglecting the

trade-off between credible and low targets.

5See Morris and Shin (2002) and Svensson (2006) for a discussion of the role of transparency in the global games

setup.

6Data are available in Eichengreen and Dincer (2009) and IMF (2005).