What is the role of inflation targeting in the real business cycle Phillips Curve?

Inflation targeting plays a significant role in the real business cycle Phillips Curve by influencing the behavior of both firms and households in response to changes in inflation expectations. The Phillips Curve represents the relationship between inflation and unemployment, suggesting that there is a trade-off between the two variables. However, the real business cycle Phillips Curve takes into account the impact of supply-side factors, such as changes in productivity and technology, on the economy.

Inflation targeting refers to a monetary policy framework where central banks set specific inflation targets and adjust their policy instruments, such as interest rates, to achieve those targets. By targeting inflation, central banks aim to maintain price stability and anchor inflation expectations. This has several implications for the real business cycle Phillips Curve.

Firstly, inflation targeting helps to anchor inflation expectations. When households and firms have confidence that inflation will remain low and stable, they are more likely to make long-term economic decisions based on those expectations. This reduces the uncertainty surrounding future inflation and allows for more efficient resource allocation in the economy.

Secondly, inflation targeting influences the behavior of firms in wage and price setting. When firms expect low and stable inflation, they are less likely to incorporate anticipated inflation into their wage and price decisions. This reduces the extent to which changes in inflation affect the real wage and price levels, leading to a flatter Phillips Curve relationship.

Thirdly, inflation targeting affects the behavior of households in their wage negotiations. When households have confidence in low and stable inflation, they are less likely to demand higher wages to compensate for expected inflation. This reduces the pressure on firms to increase wages, contributing to a flatter Phillips Curve.

Overall, inflation targeting in the real business cycle Phillips Curve helps to stabilize inflation expectations, reduce the impact of anticipated inflation on wage and price setting, and promote a flatter relationship between inflation and unemployment. This allows for a more efficient allocation of resources and supports long-term economic growth.