Does Inflation Targeting Affect the Trade-Off between Output Gap and Inflation Variability?

Abstract

We utilize a stochastic volatility model to analyse the possible effects of inflation targeting on the trade-off between output gap variability and inflation variability. We find that the adoption of inflation targets (in New Zealand, Australia, Canada, the UK, Sweden and Finland) might result in a more favourable monetary policy trade-off (except in Australia and Finland). This conclusion is reached by comparing, first, the economic performance of targeting countries in the 1980s and the 1990s; and second, the economic performance in the 1990s of targeting and non-targeting countries (the USA, Japan, Switzerland, Germany, France and the Netherlands). We focus on two possible explanations for the performance of the inflation-targeting regime: the relatively high degree of monetary policy transparency, and the presence of a flexible institutional framework.