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Optimal Price Indices for Targeting Inflation Under Incomplete Markets

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  • Rahul Anand
  • Mr. Eswar S Prasad

Abstract

In models with complete markets, targeting core inflation enables monetary policy to maximize welfare by replicating the flexible price equilibrium. We develop a two-sector two-good new-Keynesian model to study the optimal choice of price index in markets with financial frictions. We find that, in the presence of financial frictions, a welfare-maximizing central bank should adopt flexible headline inflation targeting a target for headline CPI inflation with some weight on the output gap. These results are particularly relevant for emerging markets, where the share of food expenditures in total consumption expenditures is high and a large proportion of consumers are credit constrained.

Suggested Citation

  • Rahul Anand & Mr. Eswar S Prasad, 2010. "Optimal Price Indices for Targeting Inflation Under Incomplete Markets," IMF Working Papers 2010/200, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:2010/200
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    More about this item

    Keywords

    WP; headline inflation; Inflation targeting; Monetary Policy Framework; Core Inflation; Financial Frictions; Liquidity Constraints; headline inflation inflation targeting; consumption process; core inflation inflation targeting; rule allocation; sticky price; food price inflation; elasticity of substitution; inflation targeting price index; representative core inflation targeting country; headline inflation targeting rule; targeting consumption; core inflation targeting regime; Inflation; Consumption; Sticky prices; Price indexes; Global;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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