Optimal Inflation Weights in the Euro Area

Abstract

This study investigates the appropriate measure of inflation in the euro area that the central bank should adopt in order to minimize social welfare losses stemming from volatility in the output gap, inflation and relative prices. We use a model that accounts for both the heterogeneity observed in the degree of price rigidity across regions and sectors, and the asymmetry of real disturbances in relative prices. Our work shows that the optimal weights to assign to each region or economic sector depend on complex interactions between the degree of price stickiness, a country's economic size and the distribution of shocks across regions. Moreover, the optimal system of weights is primarily affected by the distribution of real shocks across countries. It follows that there is no simple rule of thumb for establishing the optimal weights for each region or economic sector.

Sectoral Labor Mobility and Optimal Monetary Policy

“…The bottom line of our analysis is similar in spirit to that of Bragoli et al (2016) because it highlights that it is a combination of elements that the central bank has to take into account to determine the optimal inflation weights. The novel perspective we add to the debate is that the degree of sectoral labor mobility should also be part of the central bank's decision factors, given the observed sector heterogeneity and the increased importance of sector-specific shocks.…”

“…In a similar context, Petrella et al (2019) show that it is optimal to attach less weight to inflation in the durables sector. Finally, nominal rigidities and sectoral size matter for the conduct of optimal monetary policy, as demonstrated by Aoki (2001), Benigno (2004) and Bragoli et al (2016), with the general prescription that the sector with lower nominal rigidities and/or smaller in size should receive less weight in the inflation aggregator to target, but the weight does not necessarily coincide with the sector's size. We next lay out the extensions to the model described in Section 2 with durable goods.…”

“…1 This practice, however, stands in contrast to the prescription of optimal monetary policy, which suggests that sectoral weights should reflect the relative degree of price stickiness and goods durability, besides economic size (see, e.g. Aoki, 2001;Benigno, 2004;Erceg and Levin, 2006;Bragoli et al, 2016;Petrella et al, 2019; and the literature we discuss below).…”

“…The importance of asymmetric price stickiness is well established both in normative and positive analyses of multi-sector models (see e.g. Bils and Klenow, 2004;Nakamura and Steinsson, 2008;andBouakez et al, 2014 for positive analyses, andAoki, 2001;Benigno, 2004;and Bragoli et al, 2016 for normative prescriptions). Emphasis on heterogeneity in sectoral size has highlighted a contrast between the standard practice of central banks to weigh sectors by their expenditure share and the theoretical prescriptions suggesting that price stickiness is the most important feature to consider (see e.g.…”

“…Mankiw and Reis (2003) enrich these results by showing that, in order to construct a price index that-if kept on target-stabilizes economic activity, the sectoral weights should depend on the degree of price stickiness, the responsiveness to business cycles and the tendency to experience idiosyncratic shocks. Furthermore, Bragoli et al (2016) study a multi-country and a multisector model of the Euro Area with price stickiness heterogeneity across regions (or sectors). They conclude that the optimal weight to assign to inflation in each country (sector) depends on the interaction of country's (sector's) price stickiness, economic size and distribution of the relative price shock.…”