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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. 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.
  2. Kevin X.D. Huang & Zheng Liu & Louis Phaneuf, 2004. "Why Does the Cyclical Behavior of Real Wages Change Over Time?," American Economic Review, American Economic Association, vol. 94(4), pages 836-856, September.
  3. Amato, Jeffery D. & Laubach, Thomas, 2003. "Estimation and control of an optimization-based model with sticky prices and wages," Journal of Economic Dynamics and Control, Elsevier, vol. 27(7), pages 1181-1215, May.
  4. Clarida, Richard & Galí, Jordi & Gertler, Mark, 2002. "A Simple Framework for International Monetary Policy Analysis," CEPR Discussion Papers 3355, C.E.P.R. Discussion Papers.
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  11. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
  12. Marvin Goodfriend & Robert G. King, 2001. "The Case for Price Stability," NBER Working Papers 8423, National Bureau of Economic Research, Inc.
  13. Mankiw, N. Gregory & Reis, Ricardo, 2002. "What measure of inflation should a central bank target?," Working Paper Series 0170, European Central Bank.
  14. Frank Smets & Raf Wouters, 2002. "Openness, imperfect exchange rate pass-through and monetary policy," Working Paper Research 19, National Bank of Belgium.
  15. Woodford, Michael, 2000. "Optimal Monetary Policy Inertia," Seminar Papers 666, Stockholm University, Institute for International Economic Studies.
  16. 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.
  17. Taylor, John B., 1999. "Staggered price and wage setting in macroeconomics," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 15, pages 1009-1050 Elsevier.
  18. 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.
  19. Marianne Baxter & Robert G. King, 1995. "Measuring Business Cycles Approximate Band-Pass Filters for Economic Time Series," NBER Working Papers 5022, National Bureau of Economic Research, Inc.
  20. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
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