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Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables

Author

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  • Alfred V. Guender

    (Department of Economics, University of Canterbury, New Zealand)

Abstract

In open economy, a choice can be made between two measures of inflation for use as a target variable: CPI inflation or domestic inflation. This paper considers flexible and strict inflation targeting strategies and explores the circumstances under which a domestic inflation target is preferred to a CPI inflation target. This is done from the perspectives of the central bank and society as a whole. The quantitative results of this paper indicate that under suitable conditions the temporal properties of stochastic disturbances are instrumental in determining which inflation target is preferred. The choice of target variable from society’s viewpoint coincides almost perfectly with the choice of the central bank if the utility of the representative household serves as the welfare criterion for society. If qualitative aspects matter in the choice inflation target, then the role of temporal properties of the stochastic disturbances becomes less prominent. Policy conclusions are drawn with the help of a forward-looking model for a small open economy. This model has proper micro-foundations and exhibits two important features. First, the degree of openness affects the parameters of the IS relation and, second, under domestic inflation targeting, the existence of a direct exchange rate channel in the Phillips Curve impairs the perfect stabilising properties of monetary policy in the presence of demand-side disturbances.

Suggested Citation

  • Alfred V. Guender, 2004. "Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables," Macroeconomics 0404038, University Library of Munich, Germany.
  • Handle: RePEc:wpa:wuwpma:0404038
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    References listed on IDEAS

    as
    1. Samu Peura & Esa Jokivuolle, 2004. "Simulation-based stress testing of banks’ regulatory capital adequacy," Finance 0405003, University Library of Munich, Germany.
    2. Iftekhar Hasan & Heiko Schmiedel, 2004. "Do networks in the stock exchange industry pay off? European evidence," International Finance 0405002, University Library of Munich, Germany.
    3. Takalo, Tuomas & Toivanen, Otto, 2003. "Equilibrium in financial markets with adverse selection," Bank of Finland Research Discussion Papers 6/2003, Bank of Finland.
    4. Clarida, Richard & Gali, Jordi & Gertler, Mark, 2002. "A simple framework for international monetary policy analysis," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 879-904, July.
    5. repec:zbw:bofrdp:2003_005 is not listed on IDEAS
    6. repec:zbw:bofrdp:2003_011 is not listed on IDEAS
    7. repec:zbw:bofrdp:2003_006 is not listed on IDEAS
    8. repec:zbw:bofrdp:2003_010 is not listed on IDEAS
    9. repec:zbw:bofrdp:2003_008 is not listed on IDEAS
    10. George W. Evans & Seppo Honkapohja, 2003. "Friedman's Money Supply Rule vs. Optimal Interest Rate Policy," Scottish Journal of Political Economy, Scottish Economic Society, vol. 50(5), pages 550-566, November.
    11. repec:zbw:bofrdp:2003_007 is not listed on IDEAS
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    15. repec:zbw:bofrdp:2003_009 is not listed on IDEAS
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    Citations

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    Cited by:

    1. Argov, Eyal & Binyamini, Alon & Elkayam, David & Rozenshtrom, Irit, 2007. "A Small Macroeconomic Model to Support Inflation Targeting in Israel," MPRA Paper 4784, University Library of Munich, Germany.
    2. Ieva Rubene & Paolo Guarda, 2004. "The new Keynesian Phillips curve: empirical results for Luxembourg," BCL working papers 11, Central Bank of Luxembourg.

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    More about this item

    Keywords

    monetary policy; inflation target;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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