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    What to Aim for? The Choice of an Inflation Objective when Openness Matters (2016)

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    12660877_RevisionMarch9_16WhatToAimFor.pdf (1.250Mb)
    Type of Content
    Journal Article
    UC Permalink
    http://hdl.handle.net/10092/12566
    
    Publisher
    University of Canterbury. Department of Economics and Finance
    Collections
    • Business: Journal Articles [270]
    • Working Papers in Economics [142]
    Authors
    Froyen, R.T.
    Guender, A.V.
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    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 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 delivers price stability across the three inflation objectives and will be desirable to a central bank with a high aversion to inflation instability. CPI inflation targeting also does a better job of stabilizing the real exchange rate and interest rate which is an advantage from the standpoint of financial stability. REX inflation targeting does well in achieving output stability and has an advantage if 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. (2016) What to Aim for? The Choice of an Inflation Objective when Openness Matters. Open Economies Review.
    This citation is automatically generated and may be unreliable. Use as a guide only.
    Keywords
    CPI; Domestic; REX inflation targeting; openness; inflation-output trade-off
    ANZSRC Fields of Research
    15 - Commerce, Management, Tourism and Services::1502 - Banking, Finance and Investment::150201 - Finance
    Rights
    https://hdl.handle.net/10092/17651

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