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Core Inflation and Monetary Policy

  • Nessen, Marianne
  • Soderstrom, Ulf

What are the implications of targeting different measures of inflation? We extend a basic theoretical framework of optimal monetary policy under inflation targeting (Svensson 1997) to include several components of CPI inflation, and analyze the implications of using different measures of inflation as the target variable--headline CPI inflation, core inflation, and CPI excluding interest rates. Our main results are the following. First, barring the interest rate component, temporary shocks to inflation do not affect optimal monetary policy under any regime. Second, indirect (second-round) effects of disturbances on target variables need to be accounted for properly. Simply excluding seemingly temporary disturbances from the reaction function risks leading to inappropriate policy responses. Third, it may be optimal to respond to changes in one measure of inflation even if the target is defined in terms of another. Fourth, the presence of the direct interest rate component in the CPI tends to push optimal monetary policy in an expansionary direction. The net effect, considering also the traditional channel, however, depends on the nature of the initial disturbance. Copyright 2001 by Blackwell Publishers Ltd.

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Article provided by Wiley Blackwell in its journal International Finance.

Volume (Year): 4 (2001)
Issue (Month): 3 (Winter)
Pages: 401-39

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Handle: RePEc:bla:intfin:v:4:y:2001:i:3:p:401-39
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  1. Quah, Danny, 1995. "Measuring Core Inflation," CEPR Discussion Papers 1153, C.E.P.R. Discussion Papers.
  2. Orphanides, Athanasios & Wieland, Volker, 1999. "Inflation zone targeting," Working Paper Series 0008, European Central Bank.
  3. Laurence Ball, 1997. "Efficient rules for monetary policy," Reserve Bank of New Zealand Discussion Paper Series G97/3, Reserve Bank of New Zealand.
  4. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
  5. Michael F. Bryan & Stephen G. Cecchetti & Rodney L. Wiggins II, 1997. "Efficient Inflation Estimation," NBER Working Papers 6183, National Bureau of Economic Research, Inc.
  6. Stephen G. Cecchetti, 1996. "Measuring Short-Run Inflation for Central Bankers," NBER Working Papers 5786, National Bureau of Economic Research, Inc.
  7. Nicoletta Batini & Andrew G Haldane, 1999. "Forward-looking rules for monetary policy," Bank of England working papers 91, Bank of England.
  8. Michael F. Bryan & Stephen G. Cecchetti, 1993. "Measuring Core Inflation," NBER Working Papers 4303, National Bureau of Economic Research, Inc.
  9. Apel, Mikael & Jansson, Per, 1999. "A Parametric Approach for Estimating Core Inflation and Interpreting the Inflation Process," Working Paper Series 80, Sveriges Riksbank (Central Bank of Sweden).
  10. Danny Quah & Danny Quah & Shaun P. Vahey, 1995. "Measuring Core Inflation," CEP Discussion Papers dp0254, Centre for Economic Performance, LSE.
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