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Inflation targeting: What inflation rate to target?

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  • Huang, Kevin X.D.
  • Liu, Zheng

Abstract

Although CPI inflation and PPI inflation are both readily observable, the latter has received much less attention in the design of optimal monetary policy, despite the apparent difference in the cyclical behaviors of the two price indices. This paper constructs a sticky-price DSGE model, in which final consumption goods are produced through two stages of processing, and thus a natural distinction between PPI and CPI arises. We derive a utility-based objective function for a benevolent central bank, and, under this objective, we characterize optimal monetary policy and compare the welfare implications of several simple interest rate rules. Under the optimal monetary policy, the central bank should care not only about variations in CPI inflation and output gap, but also about variations in PPI inflation and the gap of the real marginal cost in the intermediate good sector. In general, the central bank faces a tradeoff between stabilizing the gaps and the two measures of inflation and cannot attain the Pareto optimal allocation. Although implementing the optimal policy requires excessive information, a simple hybrid rule under which the short-term interest rate responds to CPI inflation and PPI inflation results in a welfare level close to the optimum, while simple rules that ignore PPI inflation result in significant welfare losses.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 52 (2005)
Issue (Month): 8 (November)
Pages: 1435-1462

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Handle: RePEc:eee:moneco:v:52:y:2005:i:8:p:1435-1462

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Web page: http://www.elsevier.com/locate/inca/505566

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References

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  1. N. Gregory Mankiw & Ricardo Reis, 2002. "What Measure of Inflation Should a Central Bank Target?," NBER Working Papers 9375, National Bureau of Economic Research, Inc.
  2. Kevin X. D. Huang & Zheng Liu & Louis Phaneuf, 2003. "Why Does the Cyclical Behavior of Real Wages Change Over Time?," Emory Economics 0309, Department of Economics, Emory University (Atlanta).
  3. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
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  17. Marvin Goodfriend & Robert G. King, 2001. "The case for price stability," Working Paper 01-02, Federal Reserve Bank of Richmond.
  18. Frederic S. Mishkin & Adam S. Posen, 1997. "Inflation targeting: lessons from four countries," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 9-110.
  19. Amato, Jeffery D. & Laubach, Thomas, 2003. "Estimation and control of an optimization-based model with sticky prices and wages," Journal of Economic Dynamics and Control, Elsevier, vol. 27(7), pages 1181-1215, May.
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