Transmission Mechanism and Inflation Targeting: The Case of Colombia's Desinflation

Colombia has been on a steady disinflation path since the early 1990s. In this paper, we model the transmission mechanism of monetary policy during this disinflation. We describe how inflation evolves in response to important shocks that occurred during disinflation such as the terms of trade and to the risk premium, comparing the responses across different assumptions about inflation persistence. Disinflation itself is captured by a permanent shift to the inflation target. We evaluate to what extent a shift towards more forward-looking wage and price-setting mechanisms would determine the sacrifice ratio under disinflation.