Inefficient Shocks and Optimal Monetary Policy

63 Pages Posted: 24 Sep 2019

See all articles by Sargam Gupta

Sargam Gupta

Indira Gandhi Institute of Development Research (IGIDR), Mumbai

Date Written: September 15, 2019


The importance of trade-offs between inflation and output gap stabilization for monetary policy evaluation is well known. Real disturbances in the economy which lead to such trade-offs, however, have not been studied much in the context of monetary policy setting in emerging market and developing economies (EMDEs). We identify market price support present in the agriculture sectors of the EMDEs as a real disturbance leading to such trade-offs. Using a three-sector NK-DSGE model built in Ghate, Gupta, Mallick (2018), featuring food procurement policy in the Indian economy, we derive welfare loss function and characterize optimal monetary policy under discretion and commitment. We show that under both discretionary and commitment policy, trade-offs exist between core-inflation and output gap stabilization, and between headline inflation and output gap stabilization. This result departs from the existing popular view that strict core-inflation targeting is the optimal monetary policy for developing countries susceptible to sectoral relative-price changes. We also compare the response of the economy to a positive procurement shock and a negative productivity shock under different monetary policy rules. It is observed that an optimal simple rule with sectoral terms of trade/ relative price gaps improves welfare outcomes significantly.

Keywords: Optimal Monetary Policy, Multi-sector New Keynesian DSGE Models, Inefficient shocks, Terms of trade, Agricultural Procurement

JEL Classification: E31, E43, E52, E58, Q18

Suggested Citation

Gupta, Sargam, Inefficient Shocks and Optimal Monetary Policy (September 15, 2019). Available at SSRN: or

Sargam Gupta (Contact Author)

Indira Gandhi Institute of Development Research (IGIDR), Mumbai ( email )

Gen A.K. Vaidya Marg Santoshnagar
Goregaon (East)
Mumbai, Maharashtra 400065
02228416544 (Phone)


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