Inflation Targeting and Output Stabilization in Australia

a number of countries, including Australia, over the past decade. The adoption of a framework that focuses explicitly on inflation reflects the growing realization that the major contribution that monetary policy can make to economic growth and welfare in the long run is the maintenance of a low and stable inflation rate. Empirical evidence confirms the detrimental effects of higher inflation on economic growth. However, some have criticized inflation targeting for its perceived focus on inflation as the only goal for monetary policy, to the exclusion of other goals, most notably output (see, for example, Friedman and Kuttner, 1996). Although the empirical evidence suggests the absence of a trade-off between inflation and output in the long run, there is ample evidence of a trade-off in the short run. The short-run trade-off, often represented by the short-run Phillips curve, implies a trade-off between output variability and inflation variability. Thus an exclusive focus on returning inflation to the target rate as quickly as possible may come at the expense of excessive volatility in output. Given that the ultimate goal of policy is not inflation stabilization per se but rather welfare maximization, is inflation targeting too narrow a framework for monetary policy? Does inflation targeting pay sufficient attention to output stabilization, as, for example, a nominal income targeting framework might? This chapter considers these questions, drawing on the existing theoretical and empirical literature as well as Australia’s recent experience with inflation targeting. The chapter argues that inflation targeting does take output stabiliza-