Inflation Targeting and Macroeconomic Distortions

The paper analyses the evolution of monetary policy design in Australia over the period 1973Q3-1998Q3, highlighting the influence of macroeconomic paradigms on monetary policy design. The conventional wisdom models inflation targeting by minimizing a quadratic loss function subject to the Lucas supply curve. The theoretical analysis suggests that the exclusive focus on the institutional mechanism of Central Bank Independence (CB) while reducing inflation aversion and inflation bias is prone to gloss over the serious adverse feed-back effects on inflation bias due to macroeconomic distortions. Alternative institutional mechanisms to CBI proposed in the paper it could deliver lower inflation are discussed. A Vector-Error-Correction Model (VECM) is applied to Australian data analyze the links between CBI and other institutional proxies and macroeconomic distortions that Granger causes inflation