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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

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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Bibliographic Info

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
Date of revision:
Handle: RePEc:bca:bocawp:06-12

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Keywords: Economic models; Exchange rates; Inflation targets;

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References

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Citations

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Cited by:
  1. Jiri Bohm & Jan Filacek & Ivana Kubicova & Romana Zamazalova, 2011. "Price-Level Targeting - A Real Alternative to Inflation Targeting?," Research and Policy Notes 2011/01, Czech National Bank, Research Department.
  2. Plasmans J. & Fornero J. & Michalak T., 2006. "A microfounded sectoral model for open economies," Working Papers 2007013, University of Antwerp, Faculty of Applied Economics.
  3. Shi, Kang, 2011. "Sectoral labor adjustment and monetary policy in a small open economy," Journal of Macroeconomics, Elsevier, vol. 33(4), pages 634-643.
  4. Tervala, Juha, 2007. "Technology Shocks and Employment in Open Economies (rev.)," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, vol. 1(15 (Versi), pages 1-27.
  5. Maral Kichian & Ali Dib & Carlos de Resende, 2010. "Optimized Monetary Policy Rules in Multi-Sector Small Open Economies: The Role of Real Rigidities," 2010 Meeting Papers 184, Society for Economic Dynamics.
  6. Danny Leung, 2008. "Markups in Canada: Have They Changed and Why?," Working Papers 08-8, Bank of Canada.
  7. 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.
  8. M Farid, 2010. "Does Export Pricing Explain ‘Fear of Floating’ in Small Open Emerging Market Economies?," Discussion Papers 10/05, Department of Economics, University of York.
  9. Migliardo, Carlo, 2012. "Heterogeneity in price setting behavior, spatial disparities and sectoral diversity: Evidence from a panel of Italian firms," Economic Modelling, Elsevier, vol. 29(4), pages 1106-1118.
  10. Kang Shi & Juanyi Xu, 2008. "The Optimal Currency Basket with Input Currency and Output Currency," Working Papers 172008, Hong Kong Institute for Monetary Research.
  11. Mai Farid, . "Vertical Production and Macroeconomic Persistence: The Case of an Emerging Market Economy," Discussion Papers 09/11, Department of Economics, University of York.
  12. Xu, Juanyi, 2011. "The optimal currency basket under vertical trade," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1323-1340.
  13. Hakan, Yilmazkuday, 2009. "Is there a Role for International Trade Costs in Explaining the Central Bank Behavior?," MPRA Paper 15951, University Library of Munich, Germany.
  14. Partha Chatterjee & Malik Shukayev, 2006. "Are Average Growth Rate and Volatility Related?," Working Papers 06-24, Bank of Canada.
  15. Kang Shi & Juanyi Xu, 2008. "Input Substitution, Export Pricing, and Exchange Rate Policy," Working Papers 102008, Hong Kong Institute for Monetary Research.
  16. Donald Coletti & René Lalonde & Dirk Muir, 2008. "Inflation Targeting and Price-Level-Path Targeting in the GEM: Some Open Economy Considerations," Working Papers 08-6, Bank of Canada.
  17. Tervala, Juha, 2007. "Technology Shocks and Employment in Open Economies," Economics Discussion Papers 2007-40, Kiel Institute for the World Economy.
  18. Shi, Kang & Xu, Juanyi, 2010. "Intermediate goods trade and exchange rate pass-through," Journal of Macroeconomics, Elsevier, vol. 32(2), pages 571-583, June.

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