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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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File URL: http://cee.colmex.mx/documentos/documentos-de-trabajo/2011/dt20111.pdf
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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
Contact details of provider: Web page: http://www.colmex.mx/centros/cee/

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  1. Charles T. Carlstrom & Timothy S. Fuerst, 2003. "Investment and interest rate policy: a discrete time analysis," Working Paper 0320, Federal Reserve Bank of Cleveland.
  2. Nicoletta Batini & Paul Levine & Joseph Pearlman, 2004. "Indeterminacy with Inflation-Forecast-Based Rules in a Two-Bloc Model," School of Economics Discussion Papers 0204, School of Economics, University of Surrey.
  3. Carlstrom, Charles T. & Fuerst, Timothy S., 2001. "Timing and real indeterminacy in monetary models," Journal of Monetary Economics, Elsevier, vol. 47(2), pages 285-298, April.
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  10. Luis-Felipe Zanna, 2003. "Interest rate rules and multiple equilibria in the small open economy," International Finance Discussion Papers 785, Board of Governors of the Federal Reserve System (U.S.).
  11. De Fiore, Fiorella & Liu, Zheng, 2005. "Does trade openness matter for aggregate instability?," Journal of Economic Dynamics and Control, Elsevier, vol. 29(7), pages 1165-1192, July.
  12. William Kerr & Robert G. King, 1996. "Limits on interest rate rules in the IS model," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 47-75.
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  14. Charles T. Carlstrom & Timothy S. Fuerst, 2000. "Forward-looking versus backward-looking Taylor rules," Working Paper 0009, Federal Reserve Bank of Cleveland.
  15. Kollmann, Robert, 2003. "Monetary Policy Rules in an Interdependent World," CEPR Discussion Papers 4012, C.E.P.R. Discussion Papers.
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