Inflation Targeting and Nominal Income Growth Targeting: When and Why are They Suboptimal?

41 Pages Posted: 27 Apr 2002

See all articles by Jinill Kim

Jinill Kim

Korea University

Dale W. Henderson

Federal Reserve Board

Multiple version iconThere are 2 versions of this paper

Date Written: February 2002

Abstract

We derive optimal monetary stabilization rules and compare them to simple rules under both full and partial information. The nominal interest rate is the instrument of monetary policy. Special attention is devoted to inflation targeting and nominal-income-growth targeting. We use an optimizing-agent model of a closed economy which features monopolistic competition in both product and labor markets. A stabilization problem exists because there are one-period nominal contracts, either for wages alone or for both wages and prices, and three shocks that are unknown when contracts are signed. In order to highlight basic theoretical results, we deliberately keep our model simple enough that we can obtain exact solutions. Optimal rules maximize the expected utility of the representative agent subject to the information set of the policymaker. A key result, possibly surprising at first, is that even with monopolistic competition, the optimal full information policy makes the economy mimic the hypothetical equilibrium with flexible prices and wages. We explain why strict versions of inflation targeting, nominal income growth targeting, and other such simple rules are suboptimal under both full and partial information and derive flexible versions that are optimal under certain partial information assumptions. Nominal income growth targeting dominates inflation targeting for plausible parameter values.

Keywords: monetary policy, monetary rule, wage contracts, price contracts, full information, partial information

JEL Classification: E31, E32, E52

Suggested Citation

Kim, Jinill and Henderson, Dale W., Inflation Targeting and Nominal Income Growth Targeting: When and Why are They Suboptimal? (February 2002). Available at SSRN: https://ssrn.com/abstract=307001 or http://dx.doi.org/10.2139/ssrn.307001

Jinill Kim

Korea University ( email )

1 Anam-dong 5 ka
Seoul, 136-701

Dale W. Henderson (Contact Author)

Federal Reserve Board ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2343 (Phone)
202-736-5638 (Fax)

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