Instrument-Based vs. Target-Based Rules
Abstract
We study rules based on instruments vs. targets. Our application is a New Keynesian economy where the central bank has non-contractible information about aggregate demand shocks and cannot commit to policy. Incentives are provided to the central bank via punishment which is socially costly. Instrument-based rules condition incentives on the central bank's observable choice of policy, whereas target-based rules condition incentives on the outcomes of policy, such as inflation, which depend on both the policy choice and realized shocks. We show that the optimal rule within each class takes a threshold form, imposing the worst punishment upon violation. Target-based rules dominate instrument-based rules if and only if the central bank's information is sufficiently precise, and they are relatively more attractive the less severe the central bank's commitment problem. The optimal unconstrained rule relaxes the instrument threshold whenever the target threshold is satisfied.
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Citation
Halac, Marina, and Pierre Yared. "Instrument-Based vs. Target-Based Rules." Columbia Business School, April 15, 2020.
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