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Disinflation Costs Under Inflation Targeting In A Small Open Economy

  • Paulina Restrepo Echavarría

    ()

Since 1991, inflation in Colombia was reduced from 25% on average to about 6% more recently. Although this performance is in line with a long run inflation target of 3%, some analysts ask whether the Central Bank should continue ting. In this paper we present a dynamic stochastic general equilibrium model of inflation targeting for a small open economy to answer this question. We calibrate the model to the Colombian economy and compute the welfare cots and benefits of achieving the long run inflation target. We find that the long run welfare gains are about 4.54% in terms of capital. Furthermore,accounting for the transition the welfare gains are about 1.18% in terms of capital. Our results differ from previous findings because transition costs are introduced and our environment considers the presence of real rigidities (monopolistic competition) and nominal rigidities (sticky information) in a small open economy.We also analyze the sensitivity of the results to some key parameters and conclude that higher price flexibility leads to lower gains from reducing inflation and that a country with markups around 15% receives higher gains than those countries with different levels of markups. The weight given to the inflation gap in the monetary policy rule is important, as a more aggressive Central Bank can improve welfare. Finally,we find that disinflation is more expensive in the case of a closed economy.

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Paper provided by BANCO DE LA REPÚBLICA in its series BORRADORES DE ECONOMIA with number 002374.

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Length: 39
Date of creation: 28 Feb 2005
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Handle: RePEc:col:000094:002374
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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," NBER Working Papers 8403, National Bureau of Economic Research, Inc.
  2. Francis X. Diebold & Lee E. Ohanian & Jeremy Berkowitz, 1997. "Dynamic equilibrium economies: a framework for comparing models and data," Working Papers 97-7, Federal Reserve Bank of Philadelphia.
  3. Martha López, 2000. "Seigniorage And The Welfare Cost Of Inflation In Colombia," BORRADORES DE ECONOMIA 003488, BANCO DE LA REPÚBLICA.
  4. Franz Hamann & Juan Manuel Julio & Paulina Restrepo & Alvaro Jose Riascos Villegas, 2004. "Inflation Targeting In A Small Open Economy: The Colombian Case," BORRADORES DE ECONOMIA 002855, BANCO DE LA REPÚBLICA.
  5. Jesús Antonio Bejarano Rojas, 2005. "Estimación Estructural Y Análisis De La Curva De Phillips Neokeynesiana Para Colombia," ENSAYOS SOBRE POLÍTICA ECONÓMICA, BANCO DE LA REPÚBLICA - ESPE.
  6. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  7. Michael Dotsey & Robert G. King & Alexander L. Wolman, 1999. "State-Dependent Pricing And The General Equilibrium Dynamics Of Money And Output," The Quarterly Journal of Economics, MIT Press, vol. 114(2), pages 655-690, May.
  8. King, Robert G & Plosser, Charles I & Rebelo, Sergio T, 2002. "Production, Growth and Business Cycles: Technical Appendix," Computational Economics, Society for Computational Economics, vol. 20(1-2), pages 87-116, October.
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