Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables
AbstractIn open economy, a choice can be made between two measures of inflation for use as a target variable: CPI inflation or domestic inflation. This paper considers flexible and strict inflation targeting strategies and explores the circumstances under which a domestic inflation target is preferred to a CPI inflation target. This is done from the perspectives of the central bank and society as a whole. The quantitative results of this paper indicate that under suitable conditions the temporal properties of stochastic disturbances are instrumental in determining which inflation target is preferred. The choice of target variable from society’s viewpoint coincides almost perfectly with the choice of the central bank if the utility of the representative household serves as the welfare criterion for society. If qualitative aspects matter in the choice inflation target, then the role of temporal properties of the stochastic disturbances becomes less prominent. Policy conclusions are drawn with the help of a forward-looking model for a small open economy. This model has proper micro-foundations and exhibits two important features. First, the degree of openness affects the parameters of the IS relation and, second, under domestic inflation targeting, the existence of a direct exchange rate channel in the Phillips Curve impairs the perfect stabilising properties of monetary policy in the presence of demand-side disturbances.
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Bibliographic InfoPaper provided by Bank of Finland in its series Research Discussion Papers with number 12/2003.
Length: 58 pages
Date of creation: 12 May 2003
Date of revision:
monetary policy; inflation target;
Other versions of this item:
- Alfred V. Guender, 2004. "Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables," Macroeconomics 0404038, EconWPA.
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
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