Time Consistency and Shocks to the Natural Rate of Output

Abstract

This paper develops a model to extend the analysis of the well known "time consistency" problem based on the proposition that supply shocks can alter the natural rate ofoutput, which can induce a central bank to be time inconsistent. The effects of inflation targets and price targets are compared, and the use of both kinds of targets are shown to improve the response of the central bank under certain conditions. The analysis suggests that a flexible approach to targeting, as is practiced in countries which have tried inflation targets. has certain advantages. (E42, E52).