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The Welfare Implications of Inflation versus Price-Level Targeting in a Two-Sector, Small Open Economy

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  • Eva Ortega
  • Nooman Rebei

Abstract

The authors analyze the welfare implications of simple monetary policy rules in the context of an estimated model of a small open economy for Canada with traded and non-traded goods, and with sticky prices and wages. They find statistically significant heterogeneity in the degree of price rigidity across sectors. They also find welfare gains in targeting only the non-traded-goods inflation, since prices are found to be more sticky in this production sector, but those gains come at the cost of substantially increased aggregate volatility. The authors look for the welfare-maximizing specification of an interest rate reaction function that allows for a specific price-level target. They find, however, that, overall, the higher welfare is achieved, given the estimated model for the Canadian economy, with a strict inflation-targeting rule where the central bank reacts to the next period's expected deviation from the inflation target and does not target the output gap.

Suggested Citation

  • Eva Ortega & Nooman Rebei, 2006. "The Welfare Implications of Inflation versus Price-Level Targeting in a Two-Sector, Small Open Economy," Staff Working Papers 06-12, Bank of Canada.
  • Handle: RePEc:bca:bocawp:06-12
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    Cited by:

    1. Santacreu, Ana Maria, 2005. "Reaction functions in a small open economy: What role for non-traded inflation?," Working Papers 2014-44, Federal Reserve Bank of St. Louis.
    2. Partha Chatterjee & Malik Shukayev, 2006. "Are Average Growth Rate and Volatility Related?," Staff Working Papers 06-24, Bank of Canada.
    3. Kang Shi & Juanyi Xu, 2008. "The Optimal Currency Basket with Input Currency and Output Currency," Working Papers 172008, Hong Kong Institute for Monetary Research.
    4. Migliardo, Carlo, 2012. "Heterogeneity in price setting behavior, spatial disparities and sectoral diversity: Evidence from a panel of Italian firms," Economic Modelling, Elsevier, vol. 29(4), pages 1106-1118.
    5. Riccardo Cristadoro & Andrea Gerali & Stefano Neri & Massimiliano Pisani, 2008. "Real exchange rate volatility and disconnect: an empirical investigation," Temi di discussione (Economic working papers) 660, Bank of Italy, Economic Research and International Relations Area.
    6. PLASMANS, Joseph & FORNERO, Jorge & MICHALAK, Tomasz, 2006. "A microfounded sectoral model for open economies," Working Papers 2007013, University of Antwerp, Faculty of Applied Economics.
    7. Mai Farid, "undated". "Vertical Production and Macroeconomic Persistence: The Case of an Emerging Market Economy," Discussion Papers 09/11, Department of Economics, University of York.
    8. Tervala, Juha, 2007. "Technology Shocks and Employment in Open Economies," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy (IfW), vol. 1, pages 1-27.
    9. Shi, Kang, 2011. "Sectoral labor adjustment and monetary policy in a small open economy," Journal of Macroeconomics, Elsevier, vol. 33(4), pages 634-643.
    10. M Farid, 2010. "Does Export Pricing Explain ‘Fear of Floating’ in Small Open Emerging Market Economies?," Discussion Papers 10/05, Department of Economics, University of York.
    11. Hakan, Yilmazkuday, 2009. "Is there a Role for International Trade Costs in Explaining the Central Bank Behavior?," MPRA Paper 15951, University Library of Munich, Germany.
    12. Shi, Kang & Xu, Juanyi, 2010. "Intermediate goods trade and exchange rate pass-through," Journal of Macroeconomics, Elsevier, vol. 32(2), pages 571-583, June.
    13. Maral Kichian & Ali Dib & Carlos de Resende, 2010. "Optimized Monetary Policy Rules in Multi-Sector Small Open Economies: The Role of Real Rigidities," 2010 Meeting Papers 184, Society for Economic Dynamics.
    14. Shi, Kang & Xu, Juanyi & Yin, Xiaopeng, 2015. "Input substitution, export pricing, and exchange rate policy," Journal of International Money and Finance, Elsevier, vol. 51(C), pages 26-46.
    15. repec:kap:compec:v:51:y:2018:i:1:d:10.1007_s10614-016-9630-z is not listed on IDEAS
    16. Chetan Ghate & Sargam Gupta & Debdulal Mallick, 2018. "Terms of Trade Shocks and Monetary Policy in India," Computational Economics, Springer;Society for Computational Economics, vol. 51(1), pages 75-121, January.
    17. Danny Leung, 2008. "Markups in Canada: Have They Changed and Why?," Staff Working Papers 08-8, Bank of Canada.
    18. Dib, Ali & Mendicino, Caterina & Zhang, Yahong, 2013. "Price-level targeting rules and financial shocks: The case of Canada," Economic Modelling, Elsevier, vol. 30(C), pages 941-953.
    19. Xu, Juanyi, 2011. "The optimal currency basket under vertical trade," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1323-1340.
    20. Tervala, Juha, 2007. "Technology Shocks and Employment in Open Economies," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy (IfW), vol. 1, pages 1-27.
    21. Jiri Bohm & Jan Filacek, 2012. "Price-Level Targeting–A Real Alternative to Inflation Targeting?," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 62(1), pages 2-26, February.
    22. Donald Coletti & René Lalonde & Dirk Muir, 2008. "Inflation Targeting and Price-Level-Path Targeting in the GEM: Some Open Economy Considerations," Staff Working Papers 08-6, Bank of Canada.

    More about this item

    Keywords

    Economic models; Exchange rates; Inflation targets;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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