The Role of Inflation Target Adjustment in Stabilization Policy

Abstract How and under what circumstances can adjusting the inflation target serve as a stabilization‐policy tool and contribute to welfare improvement? We answer these questions quantitatively with a standard New Keynesian model that includes cost‐push‐type shocks. Our proposed inflation target rule calls for the target to be adjusted in a persistent manner and in the opposite direction to the realization of a cost‐push shock, which is essentially a makeup strategy. The inflation target rule, combined with a Taylor‐type rule, significantly reduces inflation fluctuations originating from cost‐push shocks and mitigates the stabilization trade‐off, resulting in a similar level of welfare to that associated with the Ramsey optimal policy.