Transmission Mechanisms and Inflation Targeting: The Case of Colombia Disinflation

Colombia has been on a steady disinflation path since the early 1990s. The paper presents a model of the transmission mechanisms of monetary policy in Colombia, in order to examine this disinflation. The model is used to describe the evolution of inflation in response to shocks to the terms of trade, the risk premium, across different monetary policy rules; and in particular, under different assumptions about the formation of inflation expectations. We then illustrate the behavior of the economy under a permanent shift to the inflation target and quantify the sacrifice ratio under different kinds of formation of inflation expectations. This helps us to judge to what extent the shift towards a more forward-looking wage and price setting affects the disinflation process and its cost. Finally, we estimate the welfare gains from disinflation and provide an inflation forecast for Colombia.

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