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Optimal monetary policy in the generalized Taylor economy

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  • Kara, Engin

Abstract

In this paper we use the Generalized Taylor Economy (GTE) framework in which there are many sectors with overlapping contracts of different lengths to analyze the design of monetary policy. We derive a utility based objective function of a central bank for this economy and use it to evaluate the performance of alternative simple rules. We find that a simple rule that targets an index that gives more weight to the sectors which have longer contracts and are more important in the aggregate index yields a welfare outcome nearly identical to the optimal policy. However, we find that potential gains in targeting sector specific inflation rates rather than the aggregate inflation rate is very sensitive to the shape of the distribution. We show that except for the cases where prices/wages are reoptimized very frequently, the performance of the sectoral rule can be closely approximated by a simple rule that targets aggregate inflation. JEL Classification: E32, E52, E58

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Paper provided by European Central Bank in its series Working Paper Series with number 0673.

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Date of creation: Sep 2006
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Handle: RePEc:ecb:ecbwps:20060673

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Keywords: inflation targeting; Optimal Monetary Policy;

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References

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  1. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
  2. Dixon, Huw David & Kara, Engin, 2008. "Can we explain inflation persistence in a way that is consistent with the micro-evidence on nominal rigidity?," Cardiff Economics Working Papers E2008/22, Cardiff University, Cardiff Business School, Economics Section.
  3. Noah Williams & Andrew Levin & Alexei Onatski, 2005. "Monetary Policy under Uncertainty in Micro-Founded Macroeconometric Models," Computing in Economics and Finance 2005, Society for Computational Economics 478, Society for Computational Economics.
  4. Emmanuel Dhyne & Luis J. Álvarez & Hervé Le Bihan & Giovanni Veronese & Daniel Dias & Johannes Hoffmann & Nicole Jonker & Patrick Lünnemann & Fabio Rumler & Jouko Vilmunen, 2005. "Price setting in the euro area: Some stylized facts from Individual Consumer Price Data," Working Papers w200506, Banco de Portugal, Economics and Research Department.
  5. Rochelle M. Edge, 2000. "The equivalence of wage and price staggering in monetary business cycle models," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 672, Board of Governors of the Federal Reserve System (U.S.).
  6. Olivier J. Blanchard & Jordi Galí, 2005. "Real wage rigidities and the New Keynesian model," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  7. Huw Dixon & Engin Kara, 2005. "How to Compare Taylor and Calvo Contracts: a comment on Michael Kiley," CDMA Working Paper Series 200504, Centre for Dynamic Macroeconomic Analysis.
  8. Ascari, G., 1997. "Optimizing Agents, Staggered Wages and Persistence in the Real Effects of Money Shocks," The Warwick Economics Research Paper Series (TWERPS) 486, University of Warwick, Department of Economics.
  9. Richard Mash, 2004. "Optimising Microfoundations for Inflation Persistence," Economics Series Working Papers 183, University of Oxford, Department of Economics.
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  11. Engin Kara & Huw Dixon, 2005. "Persistence and Nominal Inertia in a Generalised Taylor Economy: How Loner Contracts Dominate Shorter Contracts," Money Macro and Finance (MMF) Research Group Conference 2005 82, Money Macro and Finance Research Group.
  12. Mankiw, N. Gregory & Reis, Ricardo, 2002. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," Scholarly Articles 3415324, Harvard University Department of Economics.
  13. Kiley, Michael T, 2002. "Partial Adjustment and Staggered Price Setting," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 34(2), pages 283-98, May.
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  15. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers 2755, C.E.P.R. Discussion Papers.
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  17. Galí, Jordi, 2002. "New Perspectives on Monetary Policy, Inflation and the Business Cycle," CEPR Discussion Papers 3210, C.E.P.R. Discussion Papers.
  18. Rochelle M. Edge, 2001. "Online Appendix to "The Equivalence of Wage and Price Staggering in Monetary Business Cycle Models"," Technical Appendices edge01, Review of Economic Dynamics.
  19. Erceg, Christopher & Levin, Andrew, 2006. "Optimal monetary policy with durable consumption goods," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(7), pages 1341-1359, October.
  20. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, Elsevier, vol. 46(2), pages 281-313, October.
  21. Richard Mash, 2004. "Optimising microfoundations for observed inflation persistence," Money Macro and Finance (MMF) Research Group Conference 2003 60, Money Macro and Finance Research Group.
  22. Huang, Kevin X.D. & Liu, Zheng, 2005. "Inflation targeting: What inflation rate to target?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(8), pages 1435-1462, November.
  23. Sheedy, Kevin D., 2010. "Intrinsic inflation persistence," Journal of Monetary Economics, Elsevier, Elsevier, vol. 57(8), pages 1049-1061, November.
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Citations

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Cited by:
  1. Huw D. Dixon & Hervé Le Bihan, 2010. "Generalized Taylor and Generalized Calvo Price and Wage-Setting: Micro Evidence with Macro Implications," CESifo Working Paper Series 3119, CESifo Group Munich.
  2. Dixon, Huw & Kara, Engin, 2011. "Contract length heterogeneity and the persistence of monetary shocks in a dynamic generalized Taylor economy," European Economic Review, Elsevier, vol. 55(2), pages 280-292, February.
  3. Huw Dixon & Engin Kara, 2011. "Taking Multi-Sector Dynamic General Equilibrium Models to the Data," Koç University-TUSIAD Economic Research Forum Working Papers, Koc University-TUSIAD Economic Research Forum 1125, Koc University-TUSIAD Economic Research Forum.
  4. Engin Kara, 2012. "Using Micro Data on Prices to Improve Business Cycle Models," Bristol Economics Discussion Papers 12/632, Department of Economics, University of Bristol, UK.
  5. Dixon, Huw & Franklin, Jeremy & Millard, Stephen, 2014. "Sectoral shocks and monetary policy in the United Kingdom," Bank of England working papers 499, Bank of England.
  6. Engin Kara, 2011. "Understanding and Modelling Reset Price Inflation," Bristol Economics Discussion Papers 11/623, Department of Economics, University of Bristol, UK.

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