Inflation Targeting Macroeconomic Distortions and the Policy Reaction Function

Karunaratne, N. (2000) Inflation Targeting Macroeconomic Distortions and the Policy Reaction Function. Discussion Paper No 269, Department of Economics, The University of Queensland.

Attached Files (Some files may be inaccessible until you login with your UQ eSpace credentials)
Name Description MIMEType Size Downloads
DP269Jan00.pdf DP269Jan00.pdf application/pdf 669.48KB 15327
Author Karunaratne, N.
Title Inflation Targeting Macroeconomic Distortions and the Policy Reaction Function
School, Department or Centre Department of Economics
Institution The University of Queensland
Open Access Status Other
Report Number Discussion Paper No 269
Publication date 2000-01-01
Subject 340102 Macroeconomic Theory
Abstract/Summary The paper examines the evolution of monetary policy design in Australia over the past quarter of a century culminating recently in the adoption of an inflation targeting approach through the institutional mechanism of CBI (Central Bank Independence). Cross-country empirics have repeatedly confirmed the stylized fact that high CBI delivers low inflation. This study covers new ground by using time-series techniques to test the nexus between CBI and inflation using Australian quarterly time-series data for the sample period 1973Q3-1998Q4. The theoretical analysis based on a quadratic social loss function subject to a Lucas supply curve demonstrates that the exclusive focus on the institutional mechanism of CBI to reduce inflation bias may be flawed because it ignores the spillover effects of macroeconomic distortions on inflation. Time-series composite indices were constructed to proxy CBI and macroeconomic distortions in the labour market, the tax system and in the arena of international competition. The general-to-specific methodology was applied to sequentially derive a parsimonious VECM (Vector Error Correction Model) linking CBI and macroeconomic distortions to inflation during the study period. Granger causality tests indicated that both CBI and macroeconomic distortions Granger caused inflation. The VECM empirics revealed that CBI and neocorporatism contributed in a significant manner to reduction of inflation during the study period. The fact that neocorporatism curbed inflation during the study period raises the issue that the industrial relations reforms agenda aimed at eroding neocorporatism are politically motivated and lack an economic rationale. However, when the link between inflation and neocorporatism was reanalyzed taking feedback effects into account using the VAR methodology a different picture emerged. The impulse response functions revealed that an increase in neocorporatism exacerbated inflation in the short run. Thus the VAR empirics therefore provided a rationale for the labour market reforms aimed at rectifying labour market distortion attributed to neocorporatism. Both the VECM and VAR empirics make a strong case for tax reform in order to reduce welfare payments without compromising on safety net and equity issues. It also makes a case for reducing the volatility or the real exchange rate to sharpen Australia's competitive edge. The significance of macroeconomic distortions in causing output to deviate from potential underscore that the policy reaction function is influenced by distortions. Non-nested tests revealed that the Taylor rule taking account of deviations of output from potential due to macro distortions was superior to an inflation rate only rule. Therefore the study results recommend that policymaker (Reserve Bank of Australia) should pursue a Taylor rule rather than inflation rate only rule in smoothing the overnight cash rate to achieve the pre-announced inflation target.
Keyword Monetary policy - Australia
Central bank independence
Inflation targeting
References Akerlof, G.A., Dickens, W.T. and Perry, G.I. (1996) 'The Macroeconomics of Low Inflation', Brookings Papers on Economic Activity 1 :1-76. Alesina, A (1988) 'Macroeconomics and politics'. In Stanley Fischer (ed.) NBER Macroeconomic Annual. Cambridge. MIT Press. Alesina, A. Summers, L.H. (1993) 'Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence' Journal of Money Credit and Banking. 25(2): 151-162. Alesina, A. and Gatti, R. (1995) American Economic Review, 86: 196-200. American Economic Review, 85(May): 207-11. Backus, D. and Driffill, J. (1985) 'Inflation and reputation.' American Economic Review. 75: 530-538. Ball, L. (1994) 'What Determines the Sacrifice Ratio', in N.G. Mankiw (ed.) Monetary Policy, University of Chicago press: 155-152 Ball, L. (1997) 'Efficient Rules for Monetary Policy', NBER Working Paper. No. 5952 Barro, R.J. and Gordon, D.B. (1983) 'Rules, Discretion and Reputation in A Model of Monetary Policy', Journal of Monetary Economics 12(1) July: Beetsma, R.M.W.J and Jensen, H. (1998) 'Inflation Targets and Contracts with Uncertain Central Bank Preferences.' Journal of Money Credit and Banking 30(3): 384-403. Blanchard, O. and Fischer, S. (1989) Lectures in Macroeconomics. MIT Press. Cambridge/London. Blinder, A.S. (1995) 'Central Banking in Theory and Practice - Lecture II: Credibility, Discretion and Independence,' Marshall Lecture presented at the University of Cambridge. Bollerslev, T. (1986) ' Generalized Autoregressive Conditional Heteroscedasticity.' Journal of Econometrics, 31:307-327. Boskin Commission (1996) 'Towards a More Accurate Measure of the Cost of Living' Final Report in the Senate Finance Committee. Washington. D.C. Bryant, R.C., Hooper, P. and Mann, C.L. (1993) 'Design Implementation of the Empirical Simulations' in R.C. Bryant, P. Hooper and C.L. Mann (eds.), Evaluating Policy Regimes. Brookings Institution, Washington, D.C.: 219-260. Calmfors, L. and Driffill, J. (1988) 'Bargaining Structure, Corporatism and Macroeconomic Performance', Economic Policy 6: 14-61. Calvo, G. A. (1978) 'On Time Consistency of Optimal Policy in a Monetary Economy.' Econometrica 46 (November): 1411-28. Chang, R. (1998) 'Policy Credibility and the Design of Central Banks' Economic Review Federal Reserve Bank of Atlanta. Fourth Quarter: 4-15. Chapman, B. and Gruen, F. (1990) 'An Analysis of the Australian Consensual Incomes Policy: The Prices and Incomes Accord', in C. de Neubourg (ed.) The Art of Full Employment. Elsevier/North Holland. Amsterdam: 475-504. Cukierman, A. (1992) Central Bank Strategy, Credibility, and Independence: Theory and Fallacy. MIT Press. Cambridge. MA. Davidson, J.H., Hendry, D.F., F. Srba and Yeo, S. (1978) 'Econometric modelling of the aggregate time-series relationship between consumers' expenditure and income in the United Kingdom', Economic Journal, 88:661-692. Dickey, D. A. and Fuller, W.A. (1981) 'Likelihood ratio statistics for autoregressive time series with a unit root', Econometrica 49: 1057-1072. Dixit, A. (1989) 'Entry and Exit Decisions Under Uncertainty', Journal of Political Economy 97: 620-38. Doan, T. (1992) RATS 4 User's Manual. Evanston. Ill. Estima. Enders, W. (1995) Applied Economic Time Series. John Wiley and Sons. New York. Engle, R. F. and Granger, C.W. J. (1987) 'Co-integration and error correction representation, estimation and testing', Econometrica , 55: 251-276 Engle, R.F. (1982) 'Autoregressive Conditional Heteroscedasticity, with Estimates of Variance of United Kingdom Inflation', Econometrica , 50: 987-1000. EViews (1997) User's Guide. Quantitative Micro Software. Irvine. CA. USA. Fischer , S. and Summers, I. (1989) 'Should governments learn to live with inflation?' American Economic Review 79: 383-387. Goodhart, C.A.E. (1994) 'Game theory for central bankers: a report to the Governor of the Bank of England'. Journal of Economic Literature, XXII:101-104. Granger, C.W.J. (1989) 'Some recent developments in a concept of causality', Journal of Econometrics 39: 199-211. Granger, C.W.J. and Newbold (1974) 'Spurious regressions in econometrics', Journal of Econometrics 35: 143-159. Grenville, S. (1997) 'The Evolution of Monetary Policy: From Money Targets to Inflation Targets'. Monetary Policy and Inflation Targeting: Proceedings of a Conference. Phillip Lowe (ed.) Reserve Bank of Australia. Sydney. :125-158. Grilli, V., Masciandaro, D. and Tabellini, G. (1991) 'Political and monetary institutions and public financial policies in industrial countries'. Economic Policy 13; 341-392. Haldane, A.G. (1997) 'Designing Inflation Targets'. In Monetary Policy and Inflation Targeting. Proceedings of a Conference. P. Lowe (ed.). Reserve Bank of Australia. Sydney: 74-112. Haldane, A.G. (1998) 'On Inflation Targeting in the United Kingdom.' Scottish Journal of Political Economy. 45(1): 1-32. Hendry, D.F. and Doornail, JA (1996) Empirical Econometric Modelling Using PcGive 9.0 for Windows. International Thompson Business Press. London. Hordrick, R. J. and Prescott, E.C. (1980) 'Postwar US Business Cycles: an Empirical Investigation', Discussion Paper No. 451 Carnegie Mellon University. Johansen, S. (1988) 'Statistical Analysis of Cointegration Vectors', Journal of Economic Dynamics and Control, 12: 231-254. Johansen, S. and Juseilius, K. (1990) 'Maximum Likelihood Estimation and Inference on Cointegration - With Application for Demand for Money', Oxford Bulletin of Economics and Statistics, 52: 169-210. Judd, J. P and Rudebusch, G.D. (1998) 'Taylor's Rule and the Fed: 1970-1997) Federal Reserve Bank of San Francisco No. 3: 3-16. Katz, L.F. (1998) 'Reflections on US Labor Market Performance' in G. Debelle and J. Borland (Eds.) Unemployment and the Australian Labour Market. Proceedings of a Conference. Reserve Bank of Australia, Sydney and Centre for Economic Policy Research, Australian National University Canberra. Krugman, P. (1989) 'The Case of Stabilizing Exchange Rates', Oxford Review of Economic Policy. 5: 61-72. Kydland, F.E. and Prescott, E.C. (1977) 'Rules Rather than Discretion: The Inconsistency of Optimal Plans', Journal of Political Economy, 85(3): 473-492. Laxton. D., Meredith, G. and Rose, D. (1995) 'Asymmetric Effects of Economic Activity on Inflation', IMF Staff Papers 42(2): 34-374. Layard, R, Nickell, S. and Jackman, R. (1991) Unemployment: Macroeconomic Performance and the Labour Market. Oxford University Press, Oxford. Lindbeck, A. and Snower, D. (1988) The Insider-Outsider Theory of Employment and Unemployment. MIT Press. Cambridge, Mass. Lohamann, S. (1992) 'Optimal Commitment in Monetary Policy: Credibility versus Flexibility'. American Economic Review, 82(1): 273-288. Macfarlane, I.J. (1998) 'Australian Monetary Policy in the last quarter of a twentieth century'. Reserve Bank of Australia Bulletin. October 6-17. Masciandaro, D. and Tabellini, G. (1988) 'Monetary regimes and fiscal deficits: A comparative analysis'. Monetary Policy in Pacific basin countries. H.S. Cheng (ed.) Kluwer Academic Publishers. Norwell. M.A. McCallum, B.T. (1995) 'Two Fallacies Concerning Central Bank Independence.' American Economic Review 85: 207-11 Muscatelli, A. (1998) 'Optimal Contracts and Inflation Targets with Uncertain Central Bank Preferences: Accountability through Independence?' The Economic Journal, 108: 529-542. Pearson, T. and Tabellini, G. (1993) 'Designing Institutions for Monetary Stability.' Conference Series on Public Policy, 90: 58-84. Pesaran, M. H. (1982) 'On the Comprehensive Method of Testing Non-nested Regression Models.' Journal of Econometrics. 18: 263-74. Pesaran, .M. H. and Pesaran, B. (1997) Microfit 4.0 Oxford University Press. Oxford. Poole, W. (1970) 'Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model,' Quarterly Journal of Economics (May). Prast, H.M. (1998) 'Inflation, Distortionary Taxation and the Design of Monetary Policy: the Role of Social Cohesion', BNL Quarterly Review, 204: 37-53. Rogoff, K. (1985) 'The Optimal Degree of Commitment to an Intermediate Target: Inflation Gains Versus Stabilization Costs,' Quarterly Journal of Economics 100 (4) (November): 1169-89. Sargent, T.J. (1982) 'The Ends of Four Big Inflations', in R.E. Hall (ed.) Inflation Causes and Effects. University of Chicago Press. Chicago. Sims, C. (1980) 'Macroeconomics and Reality', Econometrica 48(1980): 1-49. Stemp, P.J. (1997) 'The Australian Government's Current Approach to Monetary Policy: An Evaluation' in P. Lowe (ed.) Monetary Policy and Inflation Targeting. Proceedings of a Conference Reserve Bank of Australia. Sydney. : 188-202. Stevens, G. (1992) 'Inflation and Disinflation in Australia: 1950-91,' in A. Blundell-Wignall (ed.) Inflation, Disinflation and Monetary Policy. Proceedings of a Conference. Reserve Bank of Australia: 182-244. Summers, L. (1991) 'How should long-term monetary policy be determined.' Journal of Money Credit, and Banking, 23(3) part 2: 625-31. Svensson, L.E.O. (1997) 'Optimal Inflation Targets, 'Conservative Central Banks and Linear Inflation Targets.' American Economic Review 87 (March): 98-114. Svensson, L.E.O. (1997) 'Inflation forecast targeting: Implementing and monitoring inflation targets.' European Economic Review 41: 1111-1146. Tabellini, G. (1988) 'Centralized wage setting and monetary policy in a reputational equilibrium.' Journal of Money Credit and Banking 20: 102-118. Tarantelli, E (1986) 'The regulation of inflation and employment.' Industrial Relations 25(1): 1-15. Taylor, J.B. (1993) 'Discretion Versus Policy Rules in Practice.' Carnegie-Rochester Conference Series on Public Policy. 39:195-214. Walsh, C.E. (1995) 'Optimal Contracts for Central Bankers.' American Economic Review, 85(1): 150-167. Wooden, M. and Sloan, J. (1998) 'Industrial Relations Reform and Labour Market Outcomes: A Comparison of Australia, New Zealand and the United Kingdom', in G. Debelle and J. Borland (Eds.) Unemployment and the Australian Labour Market. Proceedings of a Conference. Reserve Bank of Australia, Sydney: 169-203.

Document type: Department Technical Report
Collection: Discussion Papers (School of Economics)
Version Filter Type
Citation counts: Google Scholar Search Google Scholar
Created: Thu, 05 Feb 2004, 10:00:00 EST