Inflation Targeting - Technical Details

The Virtual Economy model allows an inflation target to be set. Perhaps the best illustration of this feature in action is when the user chooses to target inflation at its original baseline level. When the package of macroeconomic policy reform is finalised the program automatically assumes the role of the Monetary Policy Committee of the Bank of England, moving interest rates and neutralising any inflationary consequences of the changes made. The program usually picks an interest rate profile ensuring almost 100% successful inflation targeting. This is possible because the model is simply a set of deterministic equations and the role interest rates play in this economy is known with complete certainty.

The technique employed in achieving the target is called 'optimal control'. The solution software looks at the model equations and works out the relationship between interest rates and the inflation rate. Using this information the program minimises the sum of a cost function over the ten years of the simulation by setting a path for the instrument variable. Here the cost C is determined by the equation,

C=a(INFL-INFLT)² ,

where INFL is actual inflation, INFLT is the chosen target and a is the weight put on hitting the target. In the current implementation of the Virtual Economy model the weight is one. While this ensures the target is hit, it can lead to interest rate volatility feeding through the rest of the model. This can be overcome by fine-tuning the cost function and including other factors in its specification. Future versions of the Virtual Economy model may incorporate this.

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