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Should central banks’ inflation targets remain set in stone? We study a dynamic mechanism
design problem between a government and a central bank. The central bank has persistent
private information about structural shocks. Firms learn the state from the central bank’s reports
and form inflation expectations. A dynamic inflation target implements the full-information
commitment allocation. The central bank is delegated the authority to adjust the target’s level
and flexibility one period in advance. A declining natural interest rate and a flattening Phillips
curve imply opposite optimal target adjustments. Our results speak to practical policy questions
of inflation target design.
