Inflation targeting and welfare : reconsidering the Barro-Gordon model when perceived inflation and inflation expectations are interrelated

This paper aims at assessing the impact of inflation targeting on actual inflation when considering inflation perceptions together with interrelated inflation expectations, modifying the seminal papers of Barro and Gordon (1983a and 1983b). The modeling of inflation perceptions and of inflation expectations follows suggestions of recent literature, but also ideas put forward by the ECB in the immediate past. Our major findings are that already in the time consistent solution, the determination/communication of a low/moderate inflation target by the CB tends to dampen (optimal) inflation. Reviewing the four stylized strategies in the Barro-Gordon-model (cheating, fixing, taking the medicine and regaining reputation) reveals that the social costs of cheating (taking the medicine, regaining reputation) tend to be higher (lower) in our modified version. Social costs of fixing remain the same. Interrelated inflation perceptions and inflation expectations alone can hence contribute to deter CBs from leaving credible monetary policies