Inflation Target Change, Policy Credibility and Macroeconomic Effects
MA Yong, YAO Chi
School of Finance/ China Financial Policy Research Center, Renmin University of China; School of Finance,Shanghai University of International Business and Economics
Summary:
Under the China's New Normal Economy, the structural change in economic growth and the accompanying reduction of inflation pressure create conditions for the central bank to implement more strict inflation control (i.e., the reduction of inflation target). From the view of the practice of monetary policy, if the economic situation changes, the policy authority will adjust the policy target accordingly, and then carry out policy announcements as well as policy operations to promote the economy to get closer to the target state. Then, as China's economy enters to the New Normal Economy, how will the change in the inflation target affect the macroeconomy？ And how can the policy authority improve the policy effectiveness by using inflation expectation management？ Also, what is the role played by policy credibility in the performance of inflation expectation management, such as the realization of policy objectives and the dynamic operations of economy during the policy target adjustment？ These questions all need to be answered to improve inflation expectation management under the China's New Normal Economy. While there are many literatures investigating the effect of policy credibility, most of these studies are based on static/comparative static analysis or partial equilibrium analysis (e.g., analysis based on game theory), which makes it difficult to analyze the dynamic operations of economy as well as the related transmission mechanisms, and let alone discuss the dynamic structural changes in the process of policy target adjustment. The analysis of the latter requires the establishment of dynamic general equilibrium model including regime shifts, but there are very few studies on this aspect. In addition, existing literatures also don't pay enough attention to the role played by policy credibility during the adjustment of policy target or in the process of economic transition. Therefore, in order to shed new light on the questions above, this paper analyzes the structural changes during the adjustment of inflation target and discusses the role played by policy credibility in these structural changes by building a regime-switching DSGE model. Besides, we further analyze the effect of policy credibility on macroeconomic fluctuations in the process of inflation target adjustment. The results show that, when the policy authority adjusts its targets, main economic and financial variables will finally reach their equilibrium level over the target period if market participants expect this policy adjustment to be credible; on the contrary, if policy authority lacks credibility, the divergence between the policy objective and market participants' expectation will cause the main economic variables to deviate from the target equilibrium level. Moreover, we also find that policy credibility not only helps to achieve policy targets, but also has a regulation effect to reduce macroeconomic fluctuations during the policy target adjustment, thereby reducing the cost of policy implementation. And this regulation effect of policy credibility on macroeconomic fluctuations is more obvious in the medium and long term. In addition, our estimation on the structural change under the China's New Normal Economy also indicates that China's economy seems to experience a regime switching from high inflation to low inflation in 2013. Based on these results, a direct policy implication that can be drawn from our analysis is that policy authority should attach great importance to the policy credibility in the adjustment of policy target, as the reduction in the divergence between market expectations and policy objectives will make it possible to achieve better policy effects at a lower cost in the process of policy implementation. The main contributions of this paper can be concluded as follows: first, by introducing regime-switching into the traditional NK-DSGE model, this paper captures the dynamic structural changes in the process from high inflation regime to low inflation regime. Second, by comparing the case of anticipated structural change where agents' beliefs coincide with reality and the case where agents’ beliefs about the timing of the structural changes are different from the actual dates, this paper analyzes how policy credibility affects regime shifts and policy effectiveness in the process of inflation target adjustment. Third, this paper not only investigates the effect of policy credibility on the achievement of policy target, but also examines the effect of policy credibility on the cost of policy implementation, thus comprehensively analyzing the role played by policy credibility in the process of policy target adjustment. Last but not least, the analysis by using regime-switching DSGE model in this paper also enriches the related literatures and provides some new ideas as well as a new method for future studies on how policy credibility and expectation management work in the process of economic transition.
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