joint with William R. Zame

When are stabilization and inflation targeting independent objectives? The answer to this question depends on the reason for price stickiness. When stickiness is exogenous, stabilization and inflation targeting do not interact as policy goals. Instead, when price stickiness is endogenous, there is a feedback from inflation targeting to stabilization policy, as follows. A credible commitment of the central bank to a long-run target pins down inflation expectations, thereby generating greater price stickiness in the short-run. This greater price stickiness interferes with the signaling role of inflation as a guide for stabilization policy, diminishing the capability of the central bank to effectively insulate the economy from demand disturbances. This leads to a welfare loss. Taking into account how private agents react to the adoption of inflation targeting makes explicit a basic conflict between inflation targeting and stabilization policy.

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