Working Paper BETA #2007-20

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Title : A two-pillar strategy to keep inflation expectations at bay: A basic theoretical framework

Author(s) : Meixing DAI

Abstract : Using a simple macro-economic model, this study shows how a two-pillar monetary strategy as practiced by the European central bank (ECB) can be conceived to guarantee dynamic macro-economic stability and the credibility of monetary policy. This strategy can be interpreted as a combination of inflation targeting and monetary base targeting. A commitment to a long-run monetary base growth rate (monetary targeting) corresponding to inflation target could reinforce the credibility of central bank announcements and the role of inflation target as strong and credible nominal anchor for private inflation expectations. However, achieving price stability under inflationtargeting regime associated with Friedman’s money supply rule can generate dynamic instability in output, inflation and money demand. Alternative stabilizing monetary targeting rules, of which the design depends on economic structure and central bank preferences, are discussed relative to their capability to warrant dynamic macroeconomic stability.

Key-words : two-pillar monetary strategy, inflation targeting, monetary targeting, macroeconomic stability.

JEL Classification : E44, E52, E58