What is the role of inflation targeting in the new classical Phillips Curve with staggered price-setting?

Inflation targeting plays a crucial role in the new classical Phillips Curve with staggered price-setting by influencing the behavior of firms and shaping their price-setting decisions.

In this framework, inflation targeting refers to a monetary policy strategy where central banks set explicit targets for inflation rates and adjust their policy instruments to achieve these targets. The central bank communicates its inflation target to the public, which helps shape inflation expectations.

The new classical Phillips Curve with staggered price-setting assumes that firms have imperfect information about the overall price level and adjust their prices infrequently over time. As a result, firms base their price-setting decisions on their expectations of future inflation.

In this context, inflation targeting affects the behavior of firms in two main ways. Firstly, by setting a clear inflation target, the central bank provides a reference point for firms' inflation expectations. Firms take into account the central bank's target when forming their expectations of future inflation, which influences their price-setting decisions. If firms expect inflation to be higher than the target, they may increase their prices more aggressively to protect their profit margins. Conversely, if firms expect inflation to be lower than the target, they may be more cautious in raising prices.

Secondly, inflation targeting affects firms' price-setting decisions through its impact on monetary policy. When the central bank pursues an inflation targeting strategy, it adjusts its policy instruments, such as interest rates, to achieve the desired inflation target. By influencing the cost of borrowing and overall economic conditions, monetary policy affects firms' pricing decisions. For example, if the central bank raises interest rates to curb inflation, it may lead to higher borrowing costs for firms, which could dampen their pricing power and limit their ability to raise prices.

Overall, inflation targeting in the new classical Phillips Curve with staggered price-setting helps shape firms' expectations of future inflation and influences their price-setting decisions. By providing a clear inflation target and adjusting monetary policy accordingly, central banks can influence the behavior of firms and contribute to maintaining price stability in the economy.