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Inflation targeting: what inflation rate to target?

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Author Info
Kevin X. D. Huang
Zheng Liu

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Abstract

In an economy with nominal rigidities in both an intermediate good sector and a finished good sector, and thus with a natural distinction between CPI and PPI inflation rates, a benevolent central bank faces a tradeoff between stabilizing the two measures of inflation: a final output gap, and unique to our model, a real marginal cost gap in the intermediate sector, so that optimal monetary policy is second-best. We discuss how to implement the optimal policy with minimal information requirement and evaluate the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities. A main finding is that 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, whereas policy rules that ignore PPI inflation or PPI sector shocks can result in significant welfare losses.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 04-6.

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Date of creation: 2004
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Handle: RePEc:fip:fedpwp:04-6

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Keywords: Inflation (Finance);

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This paper has been announced in the following NEP Reports: References listed on IDEAS
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. Taylor, John B., 1999. "Staggered price and wage setting in macroeconomics," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 15, pages 1009-1050 Elsevier. [Downloadable!] (restricted)
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  2. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August. [Downloadable!] (restricted)
  3. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  4. Woodford, M., 1999. "Optimal Monetary Policy Inertia.," Papers 666, Stockholm - International Economic Studies.
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  5. Clarida, Richard & Gali, Jordi & Gertler, Mark, 2002. "A simple framework for international monetary policy analysis," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 879-904, July. [Downloadable!] (restricted)
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  6. Kevin X.D. Huang & Zheng Liu & Louis Phaneuf, 2004. "Why Does the Cyclical Behavior of Real Wages Change Over Time?," American Economic Review, American Economic Association, vol. 94(4), pages 836-856, September. [Downloadable!]
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  7. Marianne Baxter & Robert G. King, 1995. "Measuring Business Cycles Approximate Band-Pass Filters for Economic Time Series," NBER Working Papers 5022, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Marvin Goodfriend & Robert G. King, 2001. "The case for price stability," Working Paper 01-02, Federal Reserve Bank of Richmond. [Downloadable!]
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  9. Jordi Gali & J. David Lopez-Salido & Javier Valles, 2002. "Technology Shocks and Monetary Policy: Assessing the Fed's Performance," NBER Working Papers 8768, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October. [Downloadable!] (restricted)
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  11. Huang, Kevin X. D. & Liu, Zheng, 2001. "Production chains and general equilibrium aggregate dynamics," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 437-462, October. [Downloadable!] (restricted)
  12. 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. [Downloadable!] (restricted)
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  13. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 553-578, June. [Downloadable!] (restricted)
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  14. Frank Smets & Rafael Wouters, 2002. "Openness: imperfect exchange rate pass-through and monetary policy," Working Paper Series 128, European Central Bank. [Downloadable!]
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  15. Amato, Jeffery D. & Laubach, Thomas, 2003. "Estimation and control of an optimization-based model with sticky prices and wages," Journal of Economic Dynamics and Control, Elsevier, vol. 27(7), pages 1181-1215, May. [Downloadable!] (restricted)
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(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. Engin Kara, 2009. "Input-output connections between sectors and optimal monetary policy," Research series 200906-25, National Bank of Belgium. [Downloadable!]
  2. Mai Farid, . "Vertical Production and Macroeconomic Persistence: The Case of an Emerging Market Economy," Discussion Papers 09/11, Department of Economics, University of York. [Downloadable!]
  3. Rajeev Dhawan & Karsten Jeske, 2007. "Taylor rules with headline inflation: a bad idea," Working Paper 2007-14, Federal Reserve Bank of Atlanta. [Downloadable!]
  4. Charles Engel & Akito Matsumoto, 2009. "The International Diversification Puzzle when Goods Prices are Sticky: It's Really about Exchange-Rate Hedging, not Equity Portfolios," IMF Working Papers 09/12, International Monetary Fund. [Downloadable!]
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  5. Juan Manuel Julio & Héctor Manuel Zárate, 2008. "The Price Setting Behavior in Colombia:Evidence from PPI Micro Data," BORRADORES DE ECONOMIA 004511, BANCO DE LA REPÚBLICA. [Downloadable!]
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  6. Eva Ortega & Nooman Rebei, 2006. "The Welfare Implications of Inflation versus Price-Level Targeting in a Two-Sector, Small Open Economy," Working Papers 06-12, Bank of Canada. [Downloadable!]
  7. Louis Phaneuf & Nooman Rebei, 2008. "Production Stages and the Transmission of Technological Progress," Cahiers de recherche 0802, CIRPEE. [Downloadable!]
  8. Engin Kara, 2006. "Optimal monetary policy in the generalized Taylor economy," Working Paper Series 673, European Central Bank. [Downloadable!]
  9. Alexander L. Wolman, 2008. "Nominal frictions, relative price adjustment, and the limits to monetary policy," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 219-233. [Downloadable!]
  10. Evi Pappa & Zheng Liu, 2005. "Gains from International Monetary Policy Coordination: Does It Pay to Be Different?," Computing in Economics and Finance 2005 457, Society for Computational Economics. [Downloadable!]
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  11. Frederic S. Mishkin & Klaus Schmidt-Hebbel, 2006. "Monetary Policy Under Inflation Targeting: An Introduction," Working Papers Central Bank of Chile 396, Central Bank of Chile. [Downloadable!]
    Other versions:
  12. 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!]
  13. Zheng Liu & Evi Pappa, 2005. "Gains from Coordination in a Multi-Sector Open Economy: Does it Pay to be Different?," Working Papers 296, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University. [Downloadable!]
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  14. Erwan Gautier, 2008. "The behaviour of producer prices: evidence from French PPI micro data," Empirical Economics, Springer, vol. 35(2), pages 301-332, September. [Downloadable!] (restricted)
  15. Stefano Eusepi & Bart Hobijn & Andrea Tambalotti, 2009. "CONDI: a cost-of-nominal-distortions index," Working Paper Series 2009-03, Federal Reserve Bank of San Francisco. [Downloadable!]
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  16. Andrén, Niclas & Oxelheim, Lars, 2006. "Producer Prices in the Transition to a Common Currency," Working Paper Series 668, Research Institute of Industrial Economics. [Downloadable!]
  17. William Whitesell, 2005. "An inflation goal with multiple reference measures," Finance and Economics Discussion Series 2005-62, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  18. Louis Phaneuf & Nooman Rebei, 2007. "Technology Shocks and Business Cycles: The Role of Processing Stages and Nominal Rigidities," Working Papers 07-7, Bank of Canada. [Downloadable!]
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