Chapter 2: A Theoretical Appraisal of the Inflation–Output Dynamics Under Inflation Targeting Monetary Policy

Inflation targeting monetary policy framework came into effect in 1990s with Chile being its first witness and since it has been implemented in several other countries like United States, Australia, New Zealand, India, etc., across the world. No doubt, that the inflation targeting monetary policy has heralded a new paradigm in monetary policy-making, this new approach has had its genesis from the pressing need of aligning monetary policy with a systematic course so that it can emerge as an effective apparatus for regulating inflation. In other words, anchoring monetary policy with some macroeconomic variables, such as inflation will make it more predictable to people. Thus inflation targeting approach to monetary policy marks a striking transition in monetary policy framing from being discretionary in nature to being rule-based. In the said framework, central bank explicitly targets some specific inflation rate and announces it to the public. To put it differently, in inflation targeting framework, inflation rate acts as the nominal anchor of monetary policy. The advantage of such an approach is that it enables central bank to clamp the people’s expectations about inflation by communicating to them how it seeks to go about inflation. This in turn helps in instilling better credibility of central bank in people regarding taming of inflation and hence will affect their expectations about future inflation. Now as against this backdrop it is worth taking interest in how the inflation rate and aggregate output evolve with time under the regime of inflation targeting monetary policy. The current paper is a humble endeavor to that end.