IDEAS home Printed from https://ideas.repec.org/p/cbt/econwp/16-09.html
   My bibliography  Save this paper

What to Aim for? The Choice of an Inflation Objective When Openness Matters

Author

Listed:

Abstract

Inflation targeting countries generally define the inflation objective in terms of the consumer price index. Studies in the academic literature, however, reach conflicting conclusions concerning which measure of inflation a central bank should target in a small open economy. This paper examines the properties of domestic, CPI, and real-exchange- rate-adjusted (REX) inflation targeting. In one class of open economy New Keynesian models there is an isomorphism between optimal policy in an open versus closed economy. In the type of model we consider, where the real exchange rate appears in the Phillips curve, this isomorphism breaks down; openness matters. REX inflation targeting restores the isomorphism but this may not be desirable. Instead, under domestic and CPI inflation targeting the exchange rate channel can be exploited to enhance the effects of monetary policy. Our results indicate that CPI inflation targeting delivers price stability across the three inflation objectives and will be desirable to a central bank with a high aversion to inflation instability. CPI inflation targeting also does a better job of stabilizing the real exchange rate and interest rate which is an advantage from the standpoint of financial stability. REX inflation targeting does well in achieving output stability and has an advantage if demand shocks are predominant. In general, the choice of the inflation objective affects the trade-offs between policy goals and thus policy choices and outcomes.

Suggested Citation

  • Richard T. Froyen & Alfred V Guender, 2016. "What to Aim for? The Choice of an Inflation Objective When Openness Matters," Working Papers in Economics 16/09, University of Canterbury, Department of Economics and Finance.
  • Handle: RePEc:cbt:econwp:16/09
    as

    Download full text from publisher

    File URL: https://repec.canterbury.ac.nz/cbt/econwp/1609.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Christopher Allsopp & Amit Kara & Edward Nelson, 2006. "United Kingdom Inflation Targeting and the Exchange Rate," Economic Journal, Royal Economic Society, vol. 116(512), pages 232-244, June.
    2. Christopher A. Sims, 2012. "Statistical Modeling of Monetary Policy and Its Effects," American Economic Review, American Economic Association, vol. 102(4), pages 1187-1205, June.
    3. Eric Leeper & James Nason, 2014. "Bringing Financial Stability into Monetary Policy," CAEPR Working Papers 2014-003, Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington.
    4. Olivier Blanchard & Giovanni Dell’Ariccia & Paolo Mauro, 2010. "Rethinking Macroeconomic Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 199-215, September.
    5. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2006. "Should Central Banks Target Consumer Prices or the Exchange Rate?," Economic Journal, Royal Economic Society, vol. 116(512), pages 208-231, June.
    6. Clarida, Richard & Gali, Jordi & Gertler, Mark, 2002. "A simple framework for international monetary policy analysis," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 879-904, July.
    7. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    8. Alfred V. Guender, 2006. "Stabilising Properties of Discretionary Monetary Policies in a Small Open Economy," Economic Journal, Royal Economic Society, vol. 116(508), pages 309-326, January.
    9. Richard T. Froyen & Alfred V. Guender, 2007. "Optimal Monetary Policy under Uncertainty," Books, Edward Elgar Publishing, number 12510.
    10. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Closed versus Open Economies: An Integrated Approach," NBER Working Papers 8604, National Bureau of Economic Research, Inc.
    11. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    12. Benigno, Gianluca & Benigno, Pierpaolo, 2006. "Designing targeting rules for international monetary policy cooperation," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 473-506, April.
    13. Frank Smets, 2014. "Financial Stability and Monetary Policy: How Closely Interlinked?," International Journal of Central Banking, International Journal of Central Banking, vol. 10(2), pages 263-300, June.
    14. Philip Bunn & Colin Ellis, 2012. "How do Individual UK Producer Prices Behave?," Economic Journal, Royal Economic Society, vol. 122(558), pages 16-34, February.
    15. William Poole, 1969. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Special Studies Papers 2, Board of Governors of the Federal Reserve System (U.S.).
    16. Roberts, John M, 1995. "New Keynesian Economics and the Phillips Curve," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 975-984, November.
    17. Miles Parker, 2017. "Price-setting behaviour in New Zealand," New Zealand Economic Papers, Taylor & Francis Journals, vol. 51(3), pages 217-236, September.
    18. Froyen, Richard T. & Guender, Alfred V., 2014. "Price level targeting and the delegation issue in an open economy," Economics Letters, Elsevier, vol. 122(1), pages 12-15.
    19. De Paoli, Bianca, 2009. "Monetary policy and welfare in a small open economy," Journal of International Economics, Elsevier, vol. 77(1), pages 11-22, February.
    20. Cúrdia, Vasco & Woodford, Michael, 2011. "The central-bank balance sheet as an instrument of monetarypolicy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 54-79, January.
    21. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
    22. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
    23. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
    24. Carl E. Walsh, 2009. "Inflation Targeting: What Have We Learned?," International Finance, Wiley Blackwell, vol. 12(2), pages 195-233, August.
    25. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
    26. Anders Vredin, 2015. "Inflation targeting and financial stability: providing policymakers with relevant information," BIS Working Papers 503, Bank for International Settlements.
    27. Olivier Blanchard & Giovanni Dell'Ariccia & Paolo Mauro, 2010. "Rethinking Macroeconomic Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 199-215, September.
    28. Rotemberg, Julio J, 1982. "Sticky Prices in the United States," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1187-1211, December.
    29. Tommaso Monacelli, 2013. "Is Monetary Policy in an Open Economy Fundamentally Different?," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 61(1), pages 6-21, April.
    30. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
    31. Martin Bodenstein & Luca Guerrieri & Lutz Kilian, 2012. "Monetary Policy Responses to Oil Price Fluctuations," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 60(4), pages 470-504, December.
    32. William Poole, 1970. "Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model," The Quarterly Journal of Economics, Oxford University Press, vol. 84(2), pages 197-216.
    33. Greenslade, Jennifer & Parker, Miles, 2010. "New insights into price-setting behaviour in the United Kingdom," Bank of England working papers 395, Bank of England.
    34. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Richard T. Froyen & Alfred V Guender, 2016. "The Real Exchange Rate in Open-Economy Taylor Rules: A Re-Assessment," Working Papers in Economics 16/10, University of Canterbury, Department of Economics and Finance.
    2. Richard T Froyen & Alfred V Guender, 2015. "Real-Exchange-Rate-Adjusted Inflation Targeting in an Open Economy: Some Analytical Results," Economics Bulletin, AccessEcon, vol. 35(4), pages 2049-2059.
    3. Richard T. Froyen & Alfred V. Guender, 2019. "A Re-Evaluation of the Choice of an Inflation Target in the Wake of the Global Financial Crisis," Working Papers in Economics 19/17, University of Canterbury, Department of Economics and Finance.
    4. Alfred V. Guender & Hamish McHugh-Smith, 2020. "Financial Openness and Inflation: An Empirical Analysis," Working Papers in Economics 20/18, University of Canterbury, Department of Economics and Finance.
    5. Froyen, Richard T. & Guender, Alfred V., 2018. "The real exchange rate in Taylor rules: A Re-Assessment," Economic Modelling, Elsevier, vol. 73(C), pages 140-151.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Froyen, Richard T. & Guender, Alfred V., 2018. "The real exchange rate in Taylor rules: A Re-Assessment," Economic Modelling, Elsevier, vol. 73(C), pages 140-151.
    2. Richard T. Froyen & Alfred V Guender, 2016. "The Real Exchange Rate in Open-Economy Taylor Rules: A Re-Assessment," Working Papers in Economics 16/10, University of Canterbury, Department of Economics and Finance.
    3. Guender, Alfred V., 2011. "The timeless perspective vs. discretion: Theory and monetary policy implications for an open economy," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1638-1658.
    4. Guender, Alfred V., 2008. ""Leaning with the wind"? An open-economy example," Journal of Macroeconomics, Elsevier, vol. 30(3), pages 941-964, September.
    5. Alfred Guender & Yu Xie, 2007. "Is there an exchange rate channel in the forward-looking Phillips curve? A theoretical and empirical investigation," New Zealand Economic Papers, Taylor & Francis Journals, vol. 41(1), pages 5-28.
    6. Richard T. Froyen & Alfred V. Guender, 2012. "Instrument versus Target Rules As Specifications of Optimal Monetary Policy," International Finance, Wiley Blackwell, vol. 15(1), pages 99-123, April.
    7. Castillo, Paul & Montoro, Carlos & Tuesta, Vicente, 2009. "Money, Infation and Interest Rate: Does the Link Change when the Policy Instrument Changes?," Working Papers 2009-001, Banco Central de Reserva del Perú.
    8. Leith, Campbell & Wren-Lewis, Simon, 2009. "Taylor rules in the open economy," European Economic Review, Elsevier, vol. 53(8), pages 971-995, November.
    9. Thorvardur Tjörvi Ólafsson, 2006. "The New Keynesian Phillips Curve: In Search of Improvements and Adaptation to the Open Economy," Economics wp31_tjorvi, Department of Economics, Central bank of Iceland.
    10. Beetsma, Roel M.W.J. & Jensen, Henrik, 2005. "Monetary and fiscal policy interactions in a micro-founded model of a monetary union," Journal of International Economics, Elsevier, vol. 67(2), pages 320-352, December.
    11. Alfred Guender, 2005. "On discretion versus commitment and the role of the direct exchange rate channel in a forward-looking open economy model," International Economic Journal, Taylor & Francis Journals, vol. 19(3), pages 355-377.
    12. Beetsma, Roel M.W.J. & Jensen, Henrik, 2005. "Monetary and fiscal policy interactions in a micro-founded model of a monetary union," Journal of International Economics, Elsevier, vol. 67(2), pages 320-352, December.
    13. Yagihashi, Takeshi, 2018. "How costly is a misspecified credit channel DSGE model in monetary policymaking?," Economic Modelling, Elsevier, vol. 68(C), pages 484-505.
    14. Michael Paetz, 2007. "Robust Control and Persistence in the New Keynesian Economy," Quantitative Macroeconomics Working Papers 20711, Hamburg University, Department of Economics.
    15. Divino, Jose Angelo, 2009. "Is there a case for domestic inflation target?," Mathematics and Computers in Simulation (MATCOM), Elsevier, vol. 79(10), pages 3122-3135.
    16. Steinsson, Jon, 2003. "Optimal monetary policy in an economy with inflation persistence," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1425-1456, October.
    17. Yu-chin Chen & Pisut Kulthanavit, 2016. "Monetary Policy with Imperfect Knowledge in a Small Open Economy," PIER Discussion Papers 28., Puey Ungphakorn Institute for Economic Research, revised May 2016.
    18. Ester Faia & Tommaso Monacelli, 2008. "Optimal Monetary Policy in a Small Open Economy with Home Bias," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(4), pages 721-750, June.
    19. Rajesh Singh & Chetan Subramanian, 2008. "The optimal choice of monetary policy instruments in a small open economy," Canadian Journal of Economics/Revue canadienne d'économique, John Wiley & Sons, vol. 41(1), pages 105-137, February.
    20. Adolfson, Malin, 2001. "Monetary Policy with Incomplete Exchange Rate Pass-Through," SSE/EFI Working Paper Series in Economics and Finance 476, Stockholm School of Economics.

    More about this item

    Keywords

    CPI; Domestic; REX Inflation Targeting; Openness; Inflation-Output Trade-off;
    All these keywords.

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F3 - International Economics - - International Finance

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:cbt:econwp:16/09. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: . General contact details of provider: https://edirc.repec.org/data/decannz.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Albert Yee (email available below). General contact details of provider: https://edirc.repec.org/data/decannz.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.