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Evaluating the Monetary Policy Conducted by an Inflation-Targeting Central Bank by Simply Comparing the Actual Values for Inflation with the Inflation Target Is Surely Inadequate: First, No Central Bank Has Complete

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Submitted By mussee921
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Introduction During recent decades, inflation targeting has become one of the most significant developments in both the theory and the practice of monetary policy. An increasing number of central banks around the world have adopted this strategy as the basic framework governing their respective monetary policies (Friedman, 2004). As this trend has become hot, however, problems arises. A question worth discussing derives from those problems is that how to evaluate the monetary policy conducted by an inflation-targeting central bank. There is a view that the evaluation should not base on simply comparing the actual values for inflation with the inflation target. The reasons for this opinion is quite obvious: first, no central bank has complete control over inflation; second, in practice all central banks also care about stabilising economic activity. In the following sections of this essay, we will first consider the central bank’s responses to a temporary demand shock in detail, and then the case of an inflation shock. A conclusion will be given at the end.
A temporary demand shock Assume that there are no productivity or inflation shocks (at=ut=0), and a demand gt shock with persistence µ < 1 takes place at time 0. The natural real interest rate is given by rtn=r+φ-1gt. Substitute MPR into IS curve with the information above, and then use the method of undetermined coefficients, we can have: xt=bggt bg>0 πt-π=cggt cg>0
With the two coefficients bg and cg obeying cgbg=λ(1-βμ).
In equilibrium, the equilibrium relations as following must be verified:
ERπ,x:πt-π=(cgbg)xt=[λ(1-βμ)]xt, and
ERr,x: rt=r+dgxt, with dg>0
To illustrate the impact of the demand shock graphically, we can written as rt=φ-1Etxt+1+r+φ-1gt+[-φ-1]xt bgμgt (in equilibrium)
For PC curve, we have:

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