It is argued that inflation targeting is best understood as a commitment to a targeting rule rather than an instrument rule, eitherageneral targeting rule (explicit objectives for monetary policy) or a specific targeting rule (a criterion for (the forecasts of) the target variables to be fulfilled), essentially the equality of the marginal rates of transformation and substitution between the target variables. Targeting rules allow the use of judgment and extramodel information, are more robust and easier to verify than optimal instrument rules, and they can nevertheless bring the economy close to the socially optimal equilibrium.

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Inflation targeting is a monetary-policy strategy that is characterized by an announced numerical inflation target, an implementation of monetary policy that gives a major role to an inflation forecast and has been called forecast targeting, and a high degree of transparency and accountability. It was introduced in New Zealand in 1990, has been very successful in terms of stabilizing both inflation and the real economy, and has, as of 2010, been adopted by about 25 industrialized and emerging-market economies. The chapter discusses the history, macroeconomic effects, theory, practice, and future of inflation targeting.

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This paper presents a closed economy dynamic stochastic general equilibrium model with mo-nopolistic competition and sticky prices. Two types of price setters are assumed to exist. One acts rationally given Calvo-type constraints on price setting. The other type sets prices accord-ing to a rule-of-thumb. This results in a Phillips curve with both a forward-looking term and a backward-looking term. The theoretically appropriate central bank loss function for this model is derived. This loss function depends on the rate of change of inflation squared as well as infla-tion squared and the output gap squared. Optimal monetary policy for different relative values of the forward- and backward-looking terms is then analyzed for both the commitment case and the case of discretion. Finally the optimal Taylor rule responses to cost push supply shocks are characterized. Since the economy considered in this paper is closed the effects of international linkages on optimal monetary policy are not considered. Such effects will however be the focus of future research by the author.

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Recent work on the design of monetary policy reflects a general consensus on the appropriate objectives of monetary policy. As articulated by Svensson, “....there is considerable agreement among academics and central bankers that the appropriate loss function both involves stabilizing inflationaroundaninflation target and stabilizing the real economy, represented by the output

This paper reviews the distinction between the timeless perspective and discretionary modes of monetary policymaking, the former representing rule-based policy as recently formalized by Woodford (1999b). In models with forward-looking expectations there is typically a second inefficiency from discretionary policymaking, besides the inflationary bias. The paper presents calculations of the quantitative magnitude of this second inefficiency, using calibrated models of two prominent types; examines the distinction between instrument rules and targeting rules; and briefly investigates operationality issues involving the unobservability of current output and the possibility that an incorrect concept of the natural-rate level of output is used by the policymaker.

What accounts for the significant real effects of monetary policy shocks? And what accounts for the persistent and hump shaped responses of output and inflation in response to such shocks? These questions are investigated in a model that incorporates labor market search, habit persistence, sticky prices, and policy inertia. While habit persistence and price stickiness are important for the hump shaped output response and the long, drawn out inflation response, respectively, labor market frictions increase the output response and reduce the inflation response relative to an otherwise similar model based on a Walrasian labor market. Significantly, policy inertia itself is found to be the most important factor in accounting for the magnitude of the output effects of policy shocks in the model.

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