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Charles Freedman is Scholar in Residence in the Economics Department, Carleton University, Ottawa, Canada. Douglas Laxton is the Head of the Economic Modeling Unit of the IMF’s Research Department. This paper represents the second chapter of a manuscript that is being prepared by Charles Freedman, Douglas Laxton and Inci Otker-Robe On Developing a Full-Fledged Inflation Targeting Regime: Doing What You Say and Saying What you Do. The authors wish to thank a large number of colleagues at the Fund and other policymaking institutions for encouraging us to do this work. We also gratefully acknowledge the invaluable support of Heesun Kiem and Susanna Mursula for their research assistance, and Laura Leon for her help in the preparation of the paper. The views expressed here are those of the authors and do not necessarily reflect the position of the International Monetary Fund. The model simulation programs used in this paper can be downloaded from www.douglaslaxton.org. Correspondence: email@example.com; firstname.lastname@example.org.
It is important to emphasize that while the United States is not a formal IT country because it lacks a well-defined numerical inflation objective, the differences between the United States and the most advanced full-fledged IT countries is small, given its high levels of operational transparency. In addition, while goal transparency is a bit lower in the United States it is clear based on historical performance and communications that the Federal Reserve is committed to keeping inflation low and stable. For evidence on the benefits of IT in Canada see Longworth (2002).
This is the Third Principle of IT listed in Box 2.1 later in this chapter. An important implication of this principle is that we should be cautious not to exaggerate the role of IT in bringing about improvements in macro stability when other significant reforms contributed to reducing unemployment, raising potential output and in-creasing competition and flexibility of labor and product markets. For a discussion of the implications of these policies on the monetary transmission mechanism see Bayoumi, Laxton and Pesenti (2004).
This list is based on an update of the adoption dates reported by Roger and Stone (2005). While these dates are the ones that are typically referred to in many studies, it is important to emphasize that many of these countries started with very simple versions of IT and then improved their frameworks over time—see Batini and Laxton (2007). The adoption dates in Chapter 10 are based on the view of the national authorities and differ from those in this table for Chile and Israel.
As reviewed below, the empirical evidence suggests that high levels of inflation are likely to result in a reduction in the long-run equilibrium level of output because of the distortions that they generate.
The argument we are making here is quite general and holds even if there were more lags of inflation in the DSM.
For a summary of the history of macro modeling in policymaking institutions see The Economist (2006). Interestingly, as late as a decade ago there was still a small group of economists in the profession that argued there was little empirical evidence that the Lucas critique has much practical relevance in spite of the fact that many central banks had already been quite successful in anchoring long-term inflation expectations and reducing the persistence in the inflsation process—see Laxton and N’Diaye (2002) for some empirical evidence on the Lucas Critique.