What inflation measure should a currency union target?

Barnett, William A. and Wang, Chan and Wang, Xue and Wu, Liyuan (2018): What inflation measure should a currency union target?

Abstract

What is the appropriate inflation target for a currency union, when conducting monetary policy: core inflation or headline inflation? We answer the question in a two-country New Keynesian model with an energy sector. We derive the welfare loss function and find that optimal monetary policy should target output gaps, the terms of trade gap, the Prouder Price Index inflation rates, and the real marginal cost gaps. We use the welfare loss function to evaluate two alternative Taylor-type monetary policy rules. We find that the choice of preferred policy rule depends on the shocks. Specifically, when productivity shocks hit the economy, the policymaker should follow the headline inflation Taylor rule, while the core inflation Taylor rule should be followed when a negative energy endowment shock hits the economy.

• Item Type: MPRA Paper
• Language: English
• Keywords: Core inflation; Headline inflation; Optimal monetary policy; Currency union; Welfare.
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit; F - International Economics > F3 - International Finance; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance

References

Anand R., Prasad E., Zhang B.Y., 2015. What measure of inflation should a developing country central bank target? J. Monet. Econ. 74, 102-116.

Aoki, K., 2001. Optimal monetary policy responses to relative-price changes. J. Monet. Econ. 48(1), 55-80.

Bansal, R., Yaron, A., 2004. Risks for the long run: a potential resolution of asset pricing puzzles. J. Finance 59(4), 1481-1509.

Barnett, W. A., 2007. "Multilateral Aggregation-Theoretic Monetary Aggregation over Heterogeneous Countries," Journal of Econometrics, vol 136, no 2, 2007, pp 457-482. Reprinted in W. A. Barnett and M. Chauvet (eds.), 2011, Financial Aggregation and Index Number Theory, World Scientific, Singapore, ch. 6.

Barnett, W. A. and Duzhak, E. A., 2010. "Empirical Assessment of Bifurcation Regions within New Keynesian Models," Economic Theory, vol 45, nos 1-2, pp. 99-128.

Benigno, P., 2004. Optimal monetary policy in a currency area. J. Int. Econ. 63, 293-320.

Blanchard, O., Gali, J., 2007. Real wage rigidities and the New Keynesian model. J. Money Creidit Bank. 39, 35-65.

Bodenstein, M., Erceg, C.J., Guerrieri, L., 2008. Optimal monetary policy with distinct core and headline inflation rates. J. Monet. Econ. 55, S18--S33.

Calvo, G., 1983. Staggered prices in a utility-maximizing framework. J. Monet. Econ. 12(3), 383-398.

Clarida, R., Gali, J., Gertler, M., 2002. A simple framework for international monetary policy analysis. J. Monet. Econ. 49, 879--904.

Devereux, M.B., Shi, K., Xu, J., 2010. Oil currency and the dollar standard: a simple analytical model of an international trade currency. J. Money Credit Bank. 42(4), 521-550.

Erceg, C. J., Henderson, D.W., Levin, A.T., 2000. Optimal monetary policy with staggered wage and price contracts. J. Monet. Econ. 46(2), 281-313.

Farhi, E., Gopinath, G., Itskhoki. O., 2014. Fiscal devaluations. Rev. Econ. Stud. 81, 725-760.

Ferrero, A., 2009. Fiscal and monetary rules for a currency union. J. Int. Econ. 77(1), 1-10.

Gali, J., 2008. Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework. Princeton University Press, Princeton.

Gali, J., Monacelli, T., 2005. Monetary policy and exchange rate volatility in a small open economy. Rev. Econ. Stud. 72, 707-734.

Gali, J., Monacelli, T., 2008. Optimal monetary and fiscal policy in a currency union. J. Int. Econ. 76, 116-132.

Gali, J., Monacelli, T., 2016. Understanding the gains from wage flexibility: the exchange rate connection. Am. Econ. Rev. 106(12), 3829-3868.

Gong, L.T., Wang, C., Zou, H.F., 2016. Optimal monetary policy with international trade in intermediate inputs. J. Int. Money. Finance 65:140--165.

Gruber, J., 2006. A tax-based estimate of the elasticity of intertemporal substitution. NBER Working Paper No. 11945.

Hall, R.E., 1988. Intertemporal substitution in consumption. J. Polit. Econ. 96(2), 339-357.

Huang, K., Liu, Z., 2005. Inflation targeting: what inflation rate to target? J. Monet. Econ. 52(8), 1435-1462.

Mankiw, N.G., Reis, R., 2003. What measure of inflation should a central bank target? J. Eur. Econ. Assoc. 1(5), 1058-1086.

Nakamura, E., Steinsson, J., 2014. Fiscal stimulus in a monetary union: evidence from U.S. regions. Am. Econ. Rev. 104(3), 753-792.

Taylor, J.B., 1993. Discretion versus policy rules in practice. J. Monet. Econ. 39, 195-214.

Woodford, M., 2003. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press, Princeton.