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Inflation targeting: What inflation rate to target?

  • Huang, Kevin X.D.
  • Liu, Zheng

In an economy with nominal rigidities in both an intermediate good sector and a finished good sector, and thus with a natural distinction between CPI and PPI inflation rates, a benevolent central bank faces a tradeoff between stabilizing the two measures of inflation: a final output gap, and unique to our model, a real marginal cost gap in the intermediate sector, so that optimal monetary policy is second-best. We discuss how to implement the optimal policy with minimal information requirement and evaluate the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities. A main finding is that a simple hybrid rule under which the short-term interest rate responds to CPI inflation and PPI inflation results in a welfare level close to the optimum, whereas policy rules that ignore PPI inflation or PPI sector shocks can result in significant welfare losses.

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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 52 (2005)
Issue (Month): 8 (November)
Pages: 1435-1462

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Handle: RePEc:eee:moneco:v:52:y:2005:i:8:p:1435-1462
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

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  1. Kevin X.D. Huang & Zheng Liu & Louis Phaneuf, 2002. "Why does the cyclical behavior of real wages change over time?," Research Working Paper RWP 02-09, Federal Reserve Bank of Kansas City.
  2. Mankiw, N. Gregory & Reis, Ricardo, 2002. "What measure of inflation should a central bank target?," Working Paper Series 0170, European Central Bank.
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  4. Frederic S. Mishkin & Adam S. Posen, 1997. "Inflation targeting: lessons from four countries," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 9-110.
  5. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 553-578, June.
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