Inflation Range Targets with Hard Edges

Abstract

A number of inflation targeting central banks operate under provisions that allow for increased flexibility when faced with large supply shocks. These so-called escape clauses, however, are usually hard to interpret and discretionary in nature. This paper argues that a practical and more viable option is to specify a hard edged target range. Within the range, the central bank enjoys complete independence. Should, however, a large supply shock force inflation outside the range, the government may overrule the bank unless it adjusts its policy to address the government's concerns. Such an arrangement has the advantage of being easily understood and non-discretionary. Furthermore, it is shown that the bandwidth of the target range is inversely related to the degree of flexibility of the inflation targeting regime and thus, provides an easy way for the central bank to communicate its preferences to the public. The paper also discusses various determinants of the optimal design of the target range.