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Inflation Targeting: What Inflation Rate to Target?

  • Kevin X. D. Huang
  • Zheng Liu

Although CPI inflation and PPI inflation are both readily observable, the latter has received much less attention in the design of optimal monetary policy, despite the apparent difference in the cyclical behaviors of the two price indices. This paper constructs a sticky-price DSGE model, in which final consumption goods are produced through two stages of processing, and thus a natural distinction between PPI and CPI arises. We derive a utility-based objective function for a benevolent central bank, and, under this objective, we characterize optimal monetary policy and compare the welfare implications of several simple interest rate rules. Under the optimal monetary policy, the central bank should care not only about variations in CPI inflation and output gap, but also about variations in PPI inflation and the gap of the real marginal cost in the intermediate good sector. In general, the central bank faces a tradeoff between stabilizing the gaps and the two measures of inflation and cannot attain the Pareto optimal allocation. Although implementing the optimal policy requires excessive information, 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, while simple rules that ignore PPI inflation result in significant welfare losses.

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Paper provided by Department of Economics, Emory University (Atlanta) in its series Emory Economics with number 0318.

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Date of creation: Sep 2003
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Handle: RePEc:emo:wp2003:0318
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  1. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
  2. N. Gregory Mankiw & Ricardo Reis, 2002. "What Measure of Inflation Should a Central Bank Target?," NBER Working Papers 9375, National Bureau of Economic Research, Inc.
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  4. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
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  9. Kevin X. D. Huang & Zheng Liu & Louis Phaneuf, 2003. "Why Does the Cyclical Behavior of Real Wages Change Over Time?," Emory Economics 0309, Department of Economics, Emory University (Atlanta).
  10. Todd E. Clark, 1999. "The Responses Of Prices At Different Stages Of Production To Monetary Policy Shocks," The Review of Economics and Statistics, MIT Press, vol. 81(3), pages 420-433, August.
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  13. Bennett T. McCallum & Edward Nelson, 2000. "Nominal Income Targeting in an Open-Economy Optimizing Model," NBER Working Papers 6675, National Bureau of Economic Research, Inc.
  14. Hansen, Gary D., 1985. "Indivisible labor and the business cycle," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 309-327, November.
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  16. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
  17. Frank Smets & Raf Wouters, 2002. "Openness, imperfect exchange rate pass-through and monetary policy," Working Paper Research 19, National Bank of Belgium.
  18. Nelson, Edward, 2002. "Comment on: A simple framework for international monetary policy analysis," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 905-912, July.
  19. Benigno, Pierpaolo, 2004. "Optimal monetary policy in a currency area," Journal of International Economics, Elsevier, vol. 63(2), pages 293-320, July.
  20. 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.
  21. Huang, Kevin X. D. & Liu, Zheng, 2001. "Production chains and general equilibrium aggregate dynamics," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 437-462, October.
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