Inflation rules with consistent escape clauses

Simple inflation targets may be supplemented with an escape clause to be in voked in case the economy is hit by a major supply shock. In this paper, co nsistent solutions to the Flood and Isard (1989,IMF Staff Papers, 36, 612-6 32) escape clause model are derived in the spirit of Lohmann (1990, America n Economic Review, 82, 273-286). She shows that Flood and Isard's assumptio n of symmetric boundary values of shocks, outside of which the zero-inflati on rule should be broken, is inconsistent as long as the employment target differs from the natural rate. However, she does not actually solve the mod el. Obstfeld (1991, NBER Working Paper, No. 3603) applies this framework to an exchange-rate escape clause but is unable to solve his model given a tr iangular distribution of the supply shocks. This paper shows how the model can be solved and the optimal escape clause derived assuming a uniform dist ribution. Numerical examples suggest that the optimal boundary values in th e consistent model are highly asymmetric. (C) 1999 Elsevier Science B.V. Al l rights reserved.