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Understanding Inflation: Implications for Monetary Policy

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  • Stephen G. Cecchetti
  • Erica L. Groshen

Abstract

This paper discusses how optimal monetary policy is affected by differences in the combination of shocks an economy experiences and the rigidities it exhibits. Without both nominal rigidities and economic shocks, monetary policy would be irrelevant. Recognizing this, policymakers increasingly incorporate the understanding gained from new research on rigidities and shocks into both their policy actions and the design of monetary institutions. Specifically, shocks can be predominantly real, affecting relative prices, or primarily nominal, moving the general price level. They may also be big or small, frequent or rare. Similarly, some nominal rigidities are symmetrical, affecting both upward and downward movements equally, while others are asymmetrical, restricting decreases more than increases. After reviewing major trends in the conduct of monetary policy, we describe how the growing theoretical and empirical literature on shocks and rigidities informs three crucial dimensions of monetary policymaking. First, we discuss why trimmed means provide the best measure of core inflation. Second, we outline how rigidities impede policymakers' ability to control inflation. And third, we describe how alternative shock/rigidity combinations create inflation's grease (whereby it improves economic efficiency by speeding adjustment) and sand effects (whereby it distorts price signals) with their contrasting implications for the optimal level of inflation. We conclude by considering some key implications for monetary policy.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7482.

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Date of creation: Jan 2000
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Publication status: published as Dreze, Jacques H. (ed.) Advances in Macroeconomics, Proceedings of the Twelfth World Congress of the International Economic Association. London: Macmillan, Ltd., 2001.
Handle: RePEc:nbr:nberwo:7482

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  1. David Card & Dean Hyslop, 1996. "Does Inflation "Grease the Wheels of the Labor Market"?," NBER Working Papers 5538, National Bureau of Economic Research, Inc.
  2. Michael F. Bryan & Stephen G. Cecchetti & Rodney L. Wiggins II, 1997. "Efficient inflation estimation," Working Paper, Federal Reserve Bank of Cleveland 9707, Federal Reserve Bank of Cleveland.
  3. Friedman, Milton, 1977. "Nobel Lecture: Inflation and Unemployment," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(3), pages 451-72, June.
  4. Sheshinski, Eytan & Weiss, Yoram, 1977. "Inflation and Costs of Price Adjustment," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 44(2), pages 287-303, June.
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Cited by:
  1. Lei Lei Song, 2005. "Do underlying measures of inflation outperform headline rates? Evidence from Australian data," Applied Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 37(3), pages 339-345.
  2. Benner, Joachim & Borbély, Dóra & Gern, Klaus-Jürgen & Kamps, Christophe & Kamps, Annette & Sander, Birgit & Scheide, Joachim, 2003. "Durchgreifende Erholung der Weltkonjunktur nochmals verzögert," Open Access Publications from Kiel Institute for the World Economy, Kiel Institute for the World Economy (IfW) 2983, Kiel Institute for the World Economy (IfW).
  3. Araujo, Eurilton & Fiorencio, Antonio, 2002. "Frequency Domain Analysis of Core Inflation Measures for Brasil," Insper Working Papers, Insper Working Paper, Insper Instituto de Ensino e Pesquisa wpe_28, Insper Working Paper, Insper Instituto de Ensino e Pesquisa.
  4. Fiorencio, A & Moreira, A.R.B., 2000. "O Núcleo da Inflação como a Tendência Comum dos Preços," Insper Working Papers, Insper Working Paper, Insper Instituto de Ensino e Pesquisa wpe_2, Insper Working Paper, Insper Instituto de Ensino e Pesquisa.
  5. Martins Bitans & Dace Slakota & Ivars Tillers, 2001. "Price Dynamics in Latvia - Experience and Future Prospects," Working Papers, Latvijas Banka 2001/01, Latvijas Banka.
  6. Lei Lei Song, 2003. "The Role of the Unit of Analysis in Tax Policy Reform Evaluations," Melbourne Institute Working Paper Series, Melbourne Institute of Applied Economic and Social Research, The University of Melbourne wp2003n29, Melbourne Institute of Applied Economic and Social Research, The University of Melbourne.
  7. Pierre-Richard Agénor, 2002. "Monetary Policy under Flexible Exchange Rates: An Introduction to Inflation Targeting," Central Banking, Analysis, and Economic Policies Book Series, Central Bank of Chile, in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.), Inflation Targeting: Desing, Performance, Challenges, edition 1, volume 5, chapter 3, pages 079-170 Central Bank of Chile.
  8. Silvia Fabiani & Angela Gattulli & Roberto Sabbatini, 2003. "La rigidità dei prezzi in Italia," Moneta e Credito, Economia civile, Economia civile, vol. 56(223), pages 325-358.
  9. Luc Aucremanne & Guy Brys & Peter J Rousseeuw & Anja Struyf & Mia Hubert, 2003. "Inflation, relative prices and nominal rigidities," BIS Papers chapters, Bank for International Settlements, in: Bank for International Settlements (ed.), Monetary policy in a changing environment, volume 19, pages 81-105 Bank for International Settlements.
  10. Martins Bitans, 2002. "Real Exchange Rate in Latvia (1994-2001)," Working Papers, Latvijas Banka 2002/01, Latvijas Banka.
  11. Suvanto , Antti & Hukkinen , Juhana, 2004. "Stable price level and changing prices," Research Discussion Papers, Bank of Finland 28/2004, Bank of Finland.

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