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When does the cost channel pose a challenge to inflation targeting central banks?

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  • Smith, A. Lee

Abstract

In a sticky-price model where firms finance their production inputs, there is both a lower and an upper bound on the central bank's inflation response necessary to rule out the possibility of self-fulfilling inflation expectations. This paper shows that real wage rigidities decrease this upper bound, but coefficients in the range of those on the Taylor rule place the economy well within the determinacy region. However, when there is time-variation in the share of firms who finance their inputs (i.e. Markov-switching) then inflation targeting interest rate rules frequently result in indeterminacy, even if the central bank also targets output. Adding a nominal growth target to the policy rule can often alleviate this indeterminacy and therefore anchor inflation expectations.

Suggested Citation

  • Smith, A. Lee, 2016. "When does the cost channel pose a challenge to inflation targeting central banks?," European Economic Review, Elsevier, vol. 89(C), pages 471-494.
  • Handle: RePEc:eee:eecrev:v:89:y:2016:i:c:p:471-494
    DOI: 10.1016/j.euroecorev.2016.09.002
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    More about this item

    Keywords

    Cost channel; Taylor rule; Determinacy; Regime switching; Nominal growth;

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • C62 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Existence and Stability Conditions of Equilibrium

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