During the past two decades, industrialized countries increasingly oriented monetary policy towards reducing and maintaining low inflation. A few of them, including Canada, adopted formal inflation targets. Like many other countries, Canada's formal adoption of inflation targets at the beginning of the 1990s coincided with an economic recession and subsequent sluggish recovery throughout the first half of the 1990s.; Some analysts have attributed this poor economic performance, relative to the United States, to the Bank of Canada's low-inflation policy. More recently, a number of empirical studies have further suggested that structural factors, including downward nominal wage rigidity, contributed to Canada's persistent high unemployment during the first half of the 1990s. Although the empirical literature shows evidence of these policy-induced recessions, there is no consensus on their magnitude or degree of persistence. The intellectual debate on low-inflation policy remains intense after nearly a decade of formal inflation targeting in many industrialized countries.; The thesis constructs an annual model based on the Bank of Canada's Canadian Policy Analysis Model (CPAM). In the context of this model, the thesis contributes to the current monetary policy debate by investigating how lowering the inflation target affects the level of economic activity in the short-run and in the medium- to long-run. The thesis extends the analysis by incorporating the downward nominal wage rigidity assumption into the model, and then investigates how downward nominal wage rigidity influences the macroeconomic effects of inflation reduction.; Lowering the inflation target reduces real economic activity in the short run, but has little effect in the medium- to long-run. Setting the inflation target very low increases volatility in some sectors because achieving those targets requires relatively restrictive monetary policy. The assumption of downward nominal wage rigidity generally intensifies the recessionary effects of inflation reduction, particularly at low inflation rates. However, it does not appreciably affect macroeconomic stability.
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