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The Welfare Implications of Inflation versus Price-Level Targeting in a Two-Sector, Small Open Economy

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Author Info
Eva Ortega
Nooman Rebei

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Abstract

The authors analyze the welfare implications of simple monetary policy rules in the context of an estimated model of a small open economy for Canada with traded and non-traded goods, and with sticky prices and wages. They find statistically significant heterogeneity in the degree of price rigidity across sectors. They also find welfare gains in targeting only the non-traded-goods inflation, since prices are found to be more sticky in this production sector, but those gains come at the cost of substantially increased aggregate volatility. The authors look for the welfare-maximizing specification of an interest rate reaction function that allows for a specific price-level target. They find, however, that, overall, the higher welfare is achieved, given the estimated model for the Canadian economy, with a strict inflation-targeting rule where the central bank reacts to the next period's expected deviation from the inflation target and does not target the output gap.

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Paper provided by Bank of Canada in its series Working Papers with number 06-12.

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Length: 70 pages
Date of creation: 2006
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Handle: RePEc:bca:bocawp:06-12

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Related research
Keywords: Economic models; Exchange rates; Inflation targets;

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Find related papers by JEL classification:
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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References listed on IDEAS
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Plasmans J. & Fornero J. & Michalak T., 2006. "A microfounded sectoral model for open economies," Working Papers 2007013, University of Antwerp, Faculty of Applied Economics. [Downloadable!]
    Other versions:
  2. Ana Maria Santacreu, 2005. "Reaction functions in a small open economy: What role for non-traded inflation?," Reserve Bank of New Zealand Discussion Paper Series DP2005/04, Reserve Bank of New Zealand. [Downloadable!]
  3. Partha Chatterjee & Malik Shukayev, 2006. "Are Average Growth Rate and Volatility Related?," Working Papers 06-24, Bank of Canada. [Downloadable!]
  4. Danny Leung, 2008. "Markups in Canada: Have They Changed and Why?," Working Papers 08-8, Bank of Canada. [Downloadable!]
  5. Yilmazkuday, Hakan, 2009. "Is there a Role for International Trade Costs in Explaining the Central Bank Behavior?," MPRA Paper 15951, University Library of Munich, Germany. [Downloadable!]
  6. Riccardo Cristadoro & Andrea Gerali & Stefano Neri & Massimiliano Pisani, 2008. "Real exchange rate volatility and disconnect: an empirical investigation," Temi di discussione (Economic working papers) 660, Bank of Italy, Economic Research Department. [Downloadable!]
  7. Kang Shi & Juanyi Xu, 2008. "Input Substitution, Export Pricing, and Exchange Rate Policy," Working Papers 102008, Hong Kong Institute for Monetary Research. [Downloadable!]
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