Inflation Targeting Under Asymmetric Preferences

Abstract

This paper develops and estimates a game-theoretical model of inflation targeting where the central banker's preferences are asymmetric around the targeted rate. Specifically, positive deviations from the target can be weighted more, or less, severely than negative ones in the central banker's loss function. It is shown that some of the previous results derived under the assumption of symmetry are not robust to this generalization of preferences. Estimates of the central banker's preference parameters for Canada, Sweden, and the UK are statistically different from the one implied by the commonly used quadratic loss function. THIS PAPER DEVELOPS and estimates a game-theoretical model of monetary policy where the central banker's preferences are asymmetric around the targeted inflation rate. The preference specification permits different weights for positive and negative inflation deviations from the target and includes as a special case the quadratic loss function employed in previous literature. The symmetry of the quadratic form implies that the loss associated with an inflation deviation from the target depends solely on its magnitude. In contrast, under asymmetric preferences both the magnitude and sign of a deviation matter to the central banker. Arguments in favor of the quadratic loss function include that it is tractable, yields simple analytical results, and might provide a reasonable approximation to the central banker's preferences. On the other hand, recent anecdotal and empirical evidence appears consistent with the notion of asymmetric preferences. For example, Clarida and Gertler (1997) estimate a reaction function for the Bundesbank and find that it This paper draws on preliminary research carried out jointly with Hashem Pesaran. I am grateful to him for graciously allowing the use of material from that research here. A substantial part of this project was carried out while I was visiting research fellow at the Bank of Spain in the spring of 2000. I have received helpful comments from anonymous referees