Growth and Inflation Targeting by the Government and the Central Bank : Alignment or Conflict?

An economy is often characterised by two important objectives set for the policy makers. One regarding the growth rate of the economy and the other being the rate of inflation. A common strategy adopted by the policy makers to achieve these twin goals is to manage the interest rate through the banking system and the government enacting suitable policy to create employment. We model a stochastic dynamic optimisation problem framed in terms of the twin objectives faced by the two controlling agencies. As these objectives are not necessarily exactly aligned, it leads to a trade-off. In this paper we use a dynamic strategic interaction model under uncertainty, where the two parties involved take decisions every alternate period. First, the federal government and the central bank jointly decide a suitable target pair of values for growth and inflation, deterministic or random. Then the adjustment process is carried through in terms of employment and interest rate. We posit a suitable cost function for deviating from the target and hence formulate a joint value function to be optimised. Before analysing the actual optimisation exercise, we also settle the question whether the target is achievable in the sense of stochastic system controllablility. Finally we provide numerical results that support our conclusions. Our work informs on two issues. First, we model the duality of control between the government and the central bank -- not necessarily aligned -- to show that a trade-off solution is necessary as well as reasonable. Secondly we establish that, due to the staggered decision making, fluctuations in target achievement is inevitable and not a proof of inefficiency