Aiming for the Bull’s Eye: Uncertainty and Inertia in Monetary Policy ¤ Maria Demertzis y De Nederlandsche Bank and University of Amsterdam Nicola Viegi z University of KwaZulu-Natal October 13, 2006 Abstract We study the implications of uncertainty on the Central Bank’s ability to achieve its objectives. Assuming multiplicative uncertainty in a standard forward looking model, we show that while the role for policy is reduced in line with Brainard’s attenuation e¤ect, at the same time, the contri- bution of expectations to the …nal outcome increases. In the context of a discretionary set-up, if individuals are subject to di¤erential information according to which expectations exhibit inertia, then the system takes a long time to align with the CB’s in‡ation objective following a shock. With this in mind, we thus look for an algorithm that concentrates on removing inertia and thus bring expectations back on target. To this end, we put forward a two-step algorithm in which the in‡ation target is state contingent. The Central Bank sets (as an auxiliary step) a variable in‡a- tion target that depends on both the degree of uncertainty, as well as the shocks that occur each time. We show that such an algorithm increases the level of variability in the system but for small levels of uncertainty the cumulative bene…ts of pinning down expectations more than compen- sate the costs of having to overuse the instrument. We demonstrate this through Monte Carlo Simulations. J.E.L. Classi…cation: E42, E52 Keywords: In‡ation Targeting, Brainard Uncertainty, Two-Step Target, Di¤erential Information ¤ Views expressed are our own and do not necessarily re‡ect those of the DNB. A static model version of this paper appeared previously under the title, Aiming for the Bull’s Eye: In‡ation Targeting under Uncertainty. y Corresponding author: m.demertzis@dnb.nl, Economics and Research Division, De Ned- erlandsche Bank, P.O. Box 98, 1000 AB, Amsterdam, the Netherlands, tel: +31 (20) 524 2016, fax: +31 (20) 524 2506, www1.fee.uva.nl/toe/content/people/demertzis.shtm z viegin@nu.ac.za, Economics Department, University of KwaZulu-Natal, King George V Avenue, Durban 400, South Africa, tel: +27 31 260 3558, fax: +27 31 260 2811, www.ukzn.ac.za/economics/viegi 1