Inflation Targeting and Macroeconomic Distortions

The paper examines the evolution of monetary policy design in Australia which has culminated in the adoption of inflation targeting using the institutional mechanism of central bank independence. A Vector Error Correction Model is specified linking inflation to measures of central bank independence and macroeconomic distortions in the labour market and the tax system. The empirical results indicate that a reduction of trade union power as captured by the neocorporatist index and the reform of the tax system would reduce real exchange volatility and sharpen Australia’s competitive edge. Furthermore, the empirics indicate that implementing a Taylor feedback rule to smooth out the cash rate would deliver superior outcomes on the pre-announced inflation target.