Inflation targeting: What inflation rate to target?

Abstract

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.

Optimal monetary policy in the generalized Taylor economy

“…In particular, we compute the optimal policy that can be obtained by maximizing the welfare level de ned in (27) subject to the equilibrium conditions (19) -(26). While this is an useful reference, as discussed in Huang and Liu (2005), it is di cult to implement, as it requires the knowledge of leads and lags of the in ation rates and the output gap. Therefore, we use the central bank's rst order conditions along with the equilibrium conditions for the model to solve and calculate the level of welfare under optimal monetary policy.…”

“…As discussed in Dixon and Kara (2005b), we set LL = 4:5; which implies that intertemporal labour supply elasticity, 1= LL , is 0:2; = 6; which measures the elasticity of substitution between goods and the relative aversion in consumption, CC ; as unity. Finally, we set the i to be 0.95 and the standard deviations of innovations to productivity shocks i to 0.02, which is a standard assumption in the literature (see for example Huang and Liu (2005)). …”

Using house prices to compute the price of housing in the CPI

“…Since the consumption cost method involves computations based on house prices and (fixed, long-term) market interest rates, it offers a potentially useful tool for monetary policymakers under inflation-targeting (Huang and Liu (2005) and Mankiw and Reis (2003)). …”

Gains from Coordination in a Multi-Sector Open Economy: Does it Pay to be Different?

“…In this final step, we are essentially solving a linear-quadratic (LQ) problem with rational expectations. The LQ approach has become a popular tool in studying optimal monetary policy in closed economy models with a single sector (e.g., Rotemberg and Woodford (1997)) or multiple sectors (e.g., Erceg, et al (2000), Huang and Liu (2004b)), and in open economy models with a single traded sector (e.g., Clarida, et al (2002), Benigno and Benigno (2003), Gali andMonacelli (2002), andPappa (2004) sectors and multiple sources of nominal rigidity, for both a regime with independent central banks (i.e., the Nash regime) and one with cooperating central banks (i.e., the cooperating regime). 8…”