March 2008 issue contents
Inflation Targets as Focal Points

by Maria Demertzisa and Nicola Viegib


In a world characterized by noisy information and conflicting signals, no central bank is able to affect private-sector expectations at all times. In order to evaluate the effectiveness of any central bank communication strategy, it is important to know what private agents rely on when they form expectations. We model monetary policy as an information game in which individuals form their expectations based on all the information that is available to them (public and private) and are, therefore, subject to the noise that characterizes that information. Individual agents also know that inflation is ultimately affected both by central bank policies and by the average expectation formed by all agents. The way individuals interpret these two components to form their expectations is explained in the context of a higher-order expectations setup and is central to our argument. We then apply Bacharach's (1993) variable-universe methodology to provide a framework for assessing everyone's interpretations. Therefore, our contribution is, first, to describe monetary policy as an information game in which interpretations matter and, second, to provide a way of solving for these interpretations. We show that a monetary policy regime that has explicit quantitative objectives may provide individuals with better anchors for coordinating their expectations. However, that is only true either if no great shocks are anticipated or if all other public information is very unclear, leaving the inflation target as the only clear piece of information available. We derive the conditions under which this is true.

JEL Codes: C71, C78, E52.

Full article (PDF, 33 pages 423 kb)

a De Nederlandsche Bank and University of Amsterdam
b University of Cape Town and ERSA