Open-Economy Inflation Targeting Lars E. O. Svensson NBER Working Paper No. 6545 May 1998 JEL Nos. E52, E58, F41 Abstract This paper extends previous analysis of closed-economy inflation targeting to a small open economy with forward-looking aggregate supply and demand, and with stylized realistic lags in the different transmission channels for monetary policy. The paper compares targeting of CPI and domestic inflation, strict and flexible inflation targeting, and inflation-targeting reaction functions and the Taylor rule. The optimal monetary policy response to several different shocks is examined. Flexible CPI-inflation targeting stands out as successful in limiting not only the variability of CPI inflation but also the variability of the output gap and the real exchange rate. Somewhat counter to conventional wisdom, negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap, and induce similar monetary policy responses. The model gives limited support for a so-called monetary conditions index, MCI, of the monetary policy impact on aggregate demand, but the impact on inflation is too complex to be captured by any single index. The index differs from currently used indices in combining (1) a long rather than a short real interest rate with the real exchange rate and (2) expected future values rather than current values. Because of (2), the index is not directly observable and verifiable to external observers. Lars E. O. Svensson Institute for International Economic Studies Stockholm University 106 91 Stockholm SWEDEN and NBER Lars.Svensson@iies.su.se ## 1 Introduction During the 1990's, several countries (New Zealand, Canada, U.K., Sweden, Finland, Australia and Spain) have shifted to a new monetary policy regime, inflation targeting. This regime is characterized by (1) an explicit quantitative inflation target, either an interval or a point target, where the center of the interval or the point target currently varies across countries from 1.5 to 2.5 percent per year, (2) an operating procedure that can be described as "inflation-forecast targeting", namely the use of an internal conditional inflation forecast as an intermediate target variable, and (3) a high degree of transparency and accountability. The operating procedure can be described as inflation-forecast targeting in the following sense: The central bank's internal conditional inflation forecast (conditional upon current information, a specific instrument path, the bank's structural model(s), and judgemental adjustments of model forecasts with the use of extra-model information) is used as an intermediate target variable. An instrument path is selected that results in a conditional inflation forecast in line with a(n explicit or implicit) target for the inflation forecast (for instance, at a particular horizon, the forecast for inflation at a particular horizon equals, or is sufficiently closeOpen-Economy Inflation Targeting Lars E. O. Svensson NBER Working Paper No. 6545 May 1998 JEL Nos. E52, E58, F41 Abstract This paper extends previous analysis of closed-economy inflation targeting to a small open economy with forward-looking aggregate supply and demand, and with stylized realistic lags in the different transmission channels for monetary policy. The paper compares targeting of CPI and domestic inflation, strict and flexible inflation targeting, and inflation-targeting reaction functions and the Taylor rule. The optimal monetary policy response to several different shocks is examined. Flexible CPI-inflation targeting stands out as successful in limiting not only the variability of CPI inflation but also the variability of the output gap and the real exchange rate. Somewhat counter to conventional wisdom, negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap, and induce similar monetary policy responses. The model gives limited support for a so-called monetary conditions index, MCI, of the monetary policy impact on aggregate demand, but the impact on inflation is too complex to be captured by any single index. The index differs from currently used indices in combining (1) a long rather than a short real interest rate with the real exchange rate and (2) expected future values rather than current values. Because of (2), the index is not directly observable and verifiable to external observers. Lars E. O. Svensson Institute for International Economic Studies Stockholm University 106 91 Stockholm SWEDEN and NBER Lars.Svensson@iies.su.se ## 1 Introduction During the 1990's, several countries (New Zealand, Canada, U.K., Sweden, Finland, Australia and Spain) have shifted to a new monetary policy regime, inflation targeting. This regime is characterized by (1) an explicit quantitative inflation target, either an interval or a point target, where the center of the interval or the point target currently varies across countries from 1.5 to 2.5 percent per year, (2) an operating procedure that can be described as "inflation-forecast targeting", namely the use of an internal conditional inflation forecast as an intermediate target variable, and (3) a high degree of transparency and accountability. The operating procedure can be described as inflation-forecast targeting in the following sense: The central bank's internal conditional inflation forecast (conditional upon current information, a specific instrument path, the bank's structural model(s), and judgemental adjustments of model forecasts with the use of extra-model information) is used as an intermediate target variable. An instrument path is selected that results in a conditional inflation forecast in line with a(n explicit or implicit) target for the inflation forecast (for instance, at a particular horizon, the forecast for inflation at a particular horizon equals, or is sufficiently close