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Taylor rules with headline inflation: a bad idea

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  • Rajeev Dhawan
  • Karsten Jeske

Abstract

Should a central bank accommodate energy price shocks? Should the central bank use core inflation or headline inflation with the volatile energy component in its Taylor rule? To answer these questions, we build a dynamic stochastic general equilibrium model with energy use, durable goods, and nominal rigidities to study the effects of an energy price shock and its impact on the macroeconomy when the central bank follows a Taylor rule. We then study how the economy performs under alternative parameterizations of the rule with different weights on headline and core inflation after an increase in the energy price. Our simulation results indicate that a central bank using core inflation in its Taylor rule does better than one using headline inflation because the output drop is less severe. In general, we show that the lower the weight on energy price inflation in the Taylor rule, the impact of an energy price increase on gross domestic product and inflation is also lower.

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Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2007-14.

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Date of creation: 2007
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Handle: RePEc:fip:fedawp:2007-14

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  1. Huang, Kevin X.D. & Liu, Zheng, 2005. "Inflation targeting: What inflation rate to target?," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1435-1462, November.
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  7. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September.
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  15. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  16. Rajeev Dhawan & Karsten Jeske, 2008. "Energy Price Shocks and the Macroeconomy: The Role of Consumer Durables," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(7), pages 1357-1377, October.
  17. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
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Citations

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Cited by:
  1. Michael Plante, 2009. "How Should Monetary Policy Respond to Changes in the Relative Price of Oil? Considering Supply and Demand Shocks," Caepr Working Papers 2009-013, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  2. Jean‐Marc Natal, 2012. "Monetary Policy Response to Oil Price Shocks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(1), pages 53-101, 02.
  3. Anna Kormilitsina, 2011. "Oil Price Shocks and the Optimality of Monetary Policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(1), pages 199-223, January.
  4. James Bullard, 2011. "Measuring inflation: the core is rotten," Review, Federal Reserve Bank of St. Louis, issue July, pages 223-234.
  5. Jean Pierre Allegret & Mohamed Tahar Benkhodja, 2011. "External Shocks and Monetary Policy in a Small Open Oil Exporting Economy," EconomiX Working Papers 2011-39, University of Paris West - Nanterre la Défense, EconomiX.
  6. Romain Duval & Lukas Vogel, 2008. "Oil Price Shocks, Rigidities and the Conduct of Monetary Policy: Some Lessons from a New Keynesian Perspective," OECD Economics Department Working Papers 603, OECD Publishing.
  7. Lutz Kilian, 2008. "The Economic Effects of Energy Price Shocks," Journal of Economic Literature, American Economic Association, vol. 46(4), pages 871-909, December.
  8. Duval, Romain & Vogel, Lukas, 2007. "How do nominal and real rigidities interact? A tale of the second best," MPRA Paper 7282, University Library of Munich, Germany.
  9. Junhee Lee & Joonhyuk Song, 2009. "Nature of Oil Price Shocks and Monetary Policy," NBER Working Papers 15306, National Bureau of Economic Research, Inc.
  10. Federico di Pace, 2008. "Revisiting the Comovement Puzzle: the Input-Output Structure as an Additional Solution," Birkbeck Working Papers in Economics and Finance 0807, Birkbeck, Department of Economics, Mathematics & Statistics.
  11. Martin Bodenstein & Christopher J. Erceg & Luca Guerrieri, 2008. "Optimal monetary policy with distinct core and headline inflation rates," International Finance Discussion Papers 941, Board of Governors of the Federal Reserve System (U.S.).

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