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Inflation targeting: what inflation rate to target?

Listed author(s):
  • Kevin X. D. Huang
  • Zheng Liu

In an economy with nominal rigidities in both an intermediate good sector and a finished good sector, and thus with a natural distinction between CPI and PPI inflation rates, a benevolent central bank faces a tradeoff between stabilizing the two measures of inflation: a final output gap, and unique to our model, a real marginal cost gap in the intermediate sector, so that optimal monetary policy is second-best. We discuss how to implement the optimal policy with minimal information requirement and evaluate the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities. A main finding is that 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, whereas policy rules that ignore PPI inflation or PPI sector shocks can result in significant welfare losses.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 04-6.

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Date of creation: 2004
Handle: RePEc:fip:fedpwp:04-6
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