Flexibility in inflation targeting, financial markets and macroeconomic stability

Using an aggregate dynamic macroeconomic model, we study the macroeconomic and financial stability under flexible inflation-targeting regime associated with intermediate monetary growth target. Central banks, using the inflation target as a communication and strong nominal anchoring device, should also take into account the movements of asset prices in their optimal interest rate rule. They might react to changes in asset prices without introducing asset prices into the description of their policy objectives. We show that, the more flexible the inflation-targeting framework of monetary policy is, the more likely the monetary authorities are able to stabilise the economy around the long-term equilibrium. Therefore, achieving price stability under inflation-targeting regime with low flexibility can generate dynamic instability and will not be able to stabilise effectively the fluctuations of output and inflation. A commitment to a long run growth rate of money supply corresponding to the inflation target can reinforce the credibility of the central bank and the role of inflation target as strong and credible nominal anchor for private inflation expectations and allows the system to be more stability prone.