What to Aim For? The Choice of an Inflation Objective When Openness Matters (2013)

Type of Content
Conference Contributions - PublishedPublisher
University of Canterbury. Department of Economics and FinanceCollections
Abstract
Inflation targeting countries generally define the inflation objective in terms of the consumer price index. Studies in the academic literature, however, reach conflicting conclusions concerning which measure of inflation a central bank should target in a small open economy. This paper examines the properties of domestic, CPI, and real-exchange- rate-adjusted (REX) inflation targeting. In one class of open economy New Keynesian models there is an isomorphism between optimal monetary policy in an open versus closed economy. In the type of model we consider, where the real exchange rate appears in the Phillips curve, this isomorphism breaks down; openness matters. REX inflation targeting restores the isomorphism but this may not be desirable. Instead, under domestic and CPI inflation targeting the exchange rate channel can be exploited to enhance the effects of monetary policy. Our results indicate that CPI inflation targeting can deliver price stability across the three inflation objectives and will be desirable to a central bank with a high aversion to inflation instability. REX inflation targeting does well in delivering output stability and has a relative advantage in economies where demand shocks are predominant. In general, the choice of the inflation objective affects the trade-offs between policy goals and thus policy choices and outcomes.
Citation
Froyen, R.T., Guender, A.V. (2013) What to Aim For? The Choice of an Inflation Objective When Openness Matters. Seattle, WA, USA: Western Economic Association Meetings, 28 Jun-2 Jul 2013.This citation is automatically generated and may be unreliable. Use as a guide only.
Keywords
CPI; domestic; REX inflation targeting; discretion; timeless perspectiveANZSRC Fields of Research
15 - Commerce, Management, Tourism and Services::1502 - Banking, Finance and Investment::150201 - Finance14 - Economics::1401 - Economic Theory
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