Optimal Price Indices for Targeting Inflation Under Incomplete Markets

63 Pages Posted: 1 Feb 2011  

Rahul Anand

International Monetary Fund (IMF)

Eswar S. Prasad

Cornell University - Dyson School of Applied Economics and Management; Cornell University - Department of Economics; Brookings Institution; NBER; IZA Institute of Labor Economics

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Date Written: September 2010

Abstract

In models with complete markets, targeting core inflation enables monetary policy to maximize welfare by replicating the flexible price equilibrium. We develop a two-sector two-good new-Keynesian model to study the optimal choice of price index in markets with financial frictions. We find that, in the presence of financial frictions, a welfare-maximizing central bank should adopt flexible headline inflation targeting a target for headline CPI inflation with some weight on the output gap. These results are particularly relevant for emerging markets, where the share of food expenditures in total consumption expenditures is high and a large proportion of consumers are credit constrained.

Keywords: Consumer price indexes, Consumption, Demand, Economic models, Emerging markets, Food production, Inflation, Inflation targeting, Monetary policy, Price elasticity, Welfare

Suggested Citation

Anand, Rahul and Prasad, Eswar S., Optimal Price Indices for Targeting Inflation Under Incomplete Markets (September 2010). IMF Working Papers, Vol. , pp. 1-62, 2010. Available at SSRN: https://ssrn.com/abstract=1750688

Rahul Anand

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Eswar S. Prasad

Cornell University - Dyson School of Applied Economics and Management ( email )

440 Warren Hall
Ithaca, NY 14853
United States

HOME PAGE: http://prasad.aem.cornell.edu

Cornell University - Department of Economics ( email )

414 Uris Hall
Ithaca, NY 14853-7601
United States

Brookings Institution ( email )

1775 Massachusetts Ave, NW
Washington, DC 20036
United States

NBER ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

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