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Inflation Targeting: What Inflation Rate to Target?

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  • Kevin X. D. Huang
  • Zheng Liu

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

Paper provided by Department of Economics, Emory University (Atlanta) in its series Emory Economics with number 0318.

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Date of creation: Sep 2003
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Handle: RePEc:emo:wp2003:0318

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  17. Michael Woodford, 2003. "Optimal Interest-Rate Smoothing," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 861-886.
  18. Todd E. Clark, 1999. "The Responses Of Prices At Different Stages Of Production To Monetary Policy Shocks," The Review of Economics and Statistics, MIT Press, vol. 81(3), pages 420-433, August.
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