The main objective of this paper is to contribute to the public policy discussion regarding whether or not a growth target (or a flexible inflation target) should be assigned to the Bank of Israel by reformulating this question in a way that leads to verifiable and falsifiable propositions.

It is shown that the answer to this question depends on the structure of the economy as summarized by the objective tradeoff between stabilization of inflation and stabilization of output. If a change in the interest rate has a strong impact on inflation and little impact on output, strict inflation targeting is indicated. Otherwise, some form of growth (or flexible inflation) targeting is desirable. The paper identifies some of the basic parameters that determine this crucial tradeoff coefficient and utilizes recent estimates to evaluate it. It is also argued that the desirability of growth targeting rises the more inflationary expectations are anchored in the economy. Finally, due to the unobservability of potential output and the output gap, even optimal monetary policy is subject to serially correlated forecast errors. Flexible inflation targeting that assigns a positive weight to stabilization of the output gap leads to larger discrepancies between the actual and the full- information interest rate than strict inflation targeting. The paper also briefly evaluates the case for nominal income targeting.

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