Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/73138
Authors: 
Neuenkirch, Matthias
Tillmann, Peter
Year of Publication: 
2012
Series/Report no.: 
Joint Discussion Paper Series in Economics 35-2012
Abstract: 
In this paper we systematically evaluate how central banks respond to inflation deviations from target. We present a stylized New Keynesian model in which agents' inflation expectations are sensitive to inflation deviations from target. To (re-)establish credibility, optimal monetary policy under discretion is shown to set higher interest rates today if average inflation exceeded the target in the past. Moreover, policy responds non-linearly to past inflation gaps. This is reflected in an additional term in the central bank's optimal instrument rule, which we refer to as the credibility loss. Augmenting a standard Taylor (1993) rule with the latter term, we provide empirical evidence for the interest rate response for a sample of nine IT or quasi-IT economies. We find that past deviations from the inflation target are feeding back into the reaction function of seven central banks and that this influence is economically meaningful. A deteroriation in credibility forces central bankers to undertake larger interest rate steps (ceteris paribus).
Subjects: 
Inflation expectations
credibility
reaction function
Taylor rule
JEL: 
C32
E31
E43
E52
E58
Document Type: 
Working Paper

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