The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
This paper presents a model for Inflation Targeting under imperfect policy credibility. It modifies the conventional model in three ways: an endogenous policy credibility process, by which monetary policy can gain or lose credibility over time; non-linearities in the inflation equation and in the credibility generating process; and an explicit loss function. The model highlights problems associated with the practice of setting a series of rigid near-term inflation targets. Also, unfavorable supply shocks pose a difficult problem: an appropriate response involves an interest rate increase, some loss of output, and a period of increased inflation. A delayed response can result in a prolonged period of stagflation.