DP1457 | Inflation Targeting to Achieve Inflation Convergence in the Transition Towards EMU

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30/09/1996

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Abstract

In this paper we analyse the use of inflation targeting as a device to facilitate inflation convergence of countries outside EMU to the EMU-inflation rate, and compare it with exchange rate pegging. We find that inflation targeting suffers from a similar credibility problem as a policy of exchange rate pegging. We also find, however, that inflation targeting is inherently more sustainable than exchange rate pegging. This relates to the fact that a lack of credibility of the exchange rate peg spills over into an increasing appreciation of the currency, inviting speculative attacks and a collapse of the exchange rate peg. Inflation targeting can avoid such situations. Despite the advantages inflation targeting remains plagued by serious credibility issues. In order to reduce these problems and thereby facilitate the convergence process (by high-inflation countries), we propose to combine inflation targeting with the Rogoff-proposal to appoint a conservative central banker.