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Real indeterminacy and the timing of money in open economies

  • Stephen McKnight


    (El Colegio de México)

Should central banks target producer price inflation or consumer price inflation in the setting of monetary policy? Previous studies suggest that in order to avoid real indeterminacy and self-fulfilling fluctuations, the interest rate rule for open economies should react to producer price inflation. However, as this paper shows, the preference towards a particular inflation index crucially depends upon the timing assumption on money employed in the determinacy analysis. This timing assumption importantly determines the transactions-facilitating services of money. It is shown that the conclusions of the existing literature, that advocate targeting producer price inflation, is a by-product of adopting end-of-period timing, i.e. what matters for transactions purposes is the money one leaves the goods market with. However, we find that the conditions for equilibrium determinacy change significantly once cash-in-advance timing is adopted, i.e. what matters for current transactions is the money one enters the goods market with. Thus in stark contrast to previous studies, we show that under cash-in-advance timing, targeting consumer price inflation is preferable to targeting producer price inflation in preventing self-fulfilling expectations.

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Paper provided by El Colegio de México, Centro de Estudios Económicos in its series Serie documentos de trabajo del Centro de Estudios Económicos with number 2011-01.

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Date of creation: Mar 2011
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Handle: RePEc:emx:ceedoc:2011-01
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