The International Monetary Fund (IMF) presents the full text of the January 2001 paper entitled "Inflation Targeting with Non-Accelerating-Inflation Rate of Unemployment (NAIRU) Uncertainty and Endogenous Policy Credibility," prepared by Peter Isard, Douglas Laxton, and Ann-Charlotte Eliasson. The paper uses stochastic simulations to compare performance of monetary policy rules in linear and nonlinear variants of a macroeconomic model with NAIRU uncertainty.

This is the second chapter of a forthcoming monograph entitled "On Implementing Full-Fledged Inflation-Targeting Regimes: Saying What You Do and Doing What You Say." We begin by discussing the costs of inflation, including their role in generating boom-bust cycles. Following a general discussion of the need for a nominal anchor, we describe a specific type of monetary anchor, the inflation-targeting regime, and its two key intellectual roots-the absence of long-run trade-offs and the time-inconsistency problem. We conclude by providing a brief introduction to the way in which inflation targeting works.

We analyse the interaction between private agents? uncertainty about inflation target and the central bank's data uncertainty. In our model, private agents update their perceived inflation target and the central bank estimates unobservable economic shocks as well as the perceived inflation target. Under those two uncertainties, the learning process of both private agents and the central bank causes higher order beliefs to become relevant, and this mechanism is capable of generating high persistence and volatility of inflation even though the underlying shocks are purely transitory. We also find that the persistence and volatility become smaller as the inflation target becomes more credible, that is, the private agents' uncertainty about inflation target (and hence the bank's data uncertainty) diminishes.

We analyse the interaction between private agents' uncertainty about inflation target and the central bank's data uncertainty. In our model, private agents update their perceived inflation target and the central bank estimates unobservable economic shocks as well as the perceived inflation target. Underthose two uncertainties, the learning process of both private agents andthe central bank causes higher order beliefs to become relevant, and this mechanism is capable of generating high persistence and volatility of inflation even though the underlying shocks are purely transitory. We also findthat the persistence and volatility become smaller as the inflation target becomes more credible, that is, the private agents' uncertainty about inflation target (and hence the bank's data uncertainty) diminishes.