School of Economics and Finance

No. 491: Inflation Forecast Targeting in an Overlapping Generations Model

Gerhard Sorger , Queen Mary, University of London

May 1, 2003

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In the framework of a standard overlapping generations model, it is shown that active inflation forecast targeting reinforces mechanisms that lead to indeterminacy of the monetary steady state and to countercyclical behavior of young-age consumption. The inflation forecast targeting rule which minimizes the volatility of inflation can be active or passive, depending on the characteristics of shocks and the risk aversion of households. Inflation forecast errors are always greater under active inflation forecast targeting than under passive inflation forecast targeting or strict money growth targeting. The monetary steady state is more likely to be indeterminate under an active rule of inflation forecast targeting than under the corresponding backward-looking rule (inflation targeting), but backward-looking rules can render the monetary steady state unstable.

J.E.L classification codes: E32, E52

Keywords:Monetary policy, Inflation forecast targeting, Overlapping generations model