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Optimal Price Indices for Targeting Inflation under Incomplete Markets

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  • Anand, Rahul

    ()
    (International Monetary Fund)

  • Prasad, Eswar

    ()
    (Cornell University)

Abstract

In models with complete markets, targeting core inflation enables monetary policy to maximize welfare by replicating the flexible price equilibrium. In this paper, we develop a two-sector two-good closed economy new Keynesian model to study the optimal choice of price index in markets with financial frictions. Financial frictions that limit credit-constrained consumers’ access to financial markets make demand insensitive to interest rate fluctuations. The demand of credit-constrained consumers is determined by their real wage, which depends on prices in the flexible price sector. Thus, prices in the flexible price sector influence aggregate demand and, for monetary policy to have its desired effect, the central bank has to stabilize price movements in the flexible price sector. Also, in the presence of financial frictions, stabilizing core inflation is no longer equivalent to stabilizing output fluctuations. Our analysis suggests that in the presence of financial frictions a welfare-maximizing central bank should adopt flexible headline inflation targeting – a target based on headline rather than core inflation, and with some weight on the output gap. We discuss why these results are particularly relevant for emerging markets, where the share of food expenditures in total consumption expenditures is high and a large proportion of consumers are credit-constrained.

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Bibliographic Info

Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 5137.

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Length: 70 pages
Date of creation: Aug 2010
Date of revision:
Handle: RePEc:iza:izadps:dp5137

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Keywords: inflation targeting; monetary policy framework; core inflation; headline inflation; financial frictions; liquidity constraints;

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Citations

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Cited by:
  1. Eswar S. Prasad, 2013. "Distributional Effects of Macroeconomic Policy Choices in Emerging Market Economies," NBER Working Papers 19668, National Bureau of Economic Research, Inc.
  2. Marc Pourroy & Benjamin Carton & Dramane Coulibaly, 2012. "Food Prices and Inflation Targeting in Emerging Economies," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00768906, HAL.
  3. Michael Plante Author-X-Name-First: Michael Author-X-Name-Last: Plante, 2013. "TheLong-RunMacroeconomicImpactsofFuelSubsidies," Caepr Working Papers 2013-002, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  4. Paolo Pesenti, 2013. "Theoretical notes on commodity prices and monetary policy," BIS Papers chapters, in: Bank for International Settlements (ed.), Globalisation and inflation dynamics in Asia and the Pacific, volume 70, pages 79-90 Bank for International Settlements.
  5. Michael Plante, 2013. "The long–run macroeconomic impacts of fuel subsidies," Working Papers 1303, Federal Reserve Bank of Dallas.
  6. José de Gregorio, 2012. "Commodity Prices, Monetary Policy and Inflation," Working Papers wp359, University of Chile, Department of Economics.
  7. Changyong Rhee & Hangyong Lee, 2013. "Commodity price movements and monetary policy in Asia," BIS Papers chapters, in: Bank for International Settlements (ed.), Globalisation and inflation dynamics in Asia and the Pacific, volume 70, pages 71-77 Bank for International Settlements.

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