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Should Central Banks Target Consumer Prices or the Exchange Rate?

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Author Info
Tatiana Kirsanova
Campbell Leith
Simon Wren-Lewis

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Abstract

In this article we consider two arguments suggesting that monetary authorities in an open economy should target output price inflation and not consumer price inflation. The first suggests that output price inflation corresponds to the distortions caused by price rigidity. The second shows how policy rules involving consumer price inflation can induce instability because of the feedback from interest rates to consumer price inflation via the exchange rate. We examine both arguments in the context of an open economy which is subject to a range of shocks. We show that both arguments remain robust but that there is a case for including a terms of trade or real exchange rate gap term in the authorities' welfare function alongside the output gap and output price inflation. Copyright 2006 Royal Economic Society.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1468-0297.2006.01097.x
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Publisher Info
Article provided by Royal Economic Society in its journal The Economic Journal.

Volume (Year): 116 (2006)
Issue (Month): 512 (06)
Pages: F208-F231
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Handle: RePEc:ecj:econjl:v:116:y:2006:i:512:p:f208-f231

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  1. Cambell Leith & Simon Wren-Lewis, 2006. " The Optimal Monetary Policy Response to Exchange Rate Misalignments," CDMA Conference Paper Series 0605, Centre for Dynamic Macroeconomic Analysis. [Downloadable!]
    Other versions:
  2. Ozge Senay, 2007. " Interest Rate Rules and Welfare in Open Economies," CDMA Working Paper Series 0715, Centre for Dynamic Macroeconomic Analysis. [Downloadable!]
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  3. Campbell Leith & Ioana Moldovan & Raffaele Rossi, 2009. "Monetary and fiscal policy under deep habits," Working Papers 2009_32, Department of Economics, University of Glasgow. [Downloadable!]
  4. Fernando Alexandre & Pedro Bação & John Driffill, 2007. "Optimal monetary policy with a regime-switching exchange rate in a forward-looking model," GEMF Working Papers 2007-09, GEMF - Faculdade de Economia, Universidade de Coimbra. [Downloadable!]
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  5. Fabian Eser & Campbell Leith & Simon Wren-Lewis, 2009. "When is monetary policy all we need?," Working Papers 2009_18, Department of Economics, University of Glasgow. [Downloadable!]
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  6. Tatiana Kirsanova & Simon Wren-Lewis, 2007. "Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities," Economics Series Working Papers 306, University of Oxford, Department of Economics. [Downloadable!]
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  7. Campbell Leith & Ioana Moldovan & Raffaele Rossi, 2008. "Optimal monetary policy in a new Keynesian model with habits in consumption," Working Papers 2008_30, Department of Economics, University of Glasgow, revised Dec 2008. [Downloadable!]
    Other versions:
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