Inflation Persistence and Optimal Monetary Policy in the Euro Area

42 Pages Posted: 14 Jan 2003

See all articles by Pierpaolo Benigno

Pierpaolo Benigno

LUISS Guido Carli University; Einaudi Institute for Economics and Finance (EIEF)

David Lopez-Salido

Board of Governors of the Federal Reserve System

Date Written: December 2002

Abstract

In this paper we present supporting evidence of the existence of heterogeneity in inflation dynamics across euro area countries. Based on the estimation of New Phillips Curves for five major countries of the euro area, we find that there is significant inertial (backward looking) behavior in inflation in four of them, while inflation in Germany has a dominant forward looking component. We then present an optimizing agent model for the area emphasizing the heterogeneity in inflation persistence across regions. Allowing for such a backward looking component will affect the evaluation of the degree of nominal rigidities relevant for the monetary policy design. We explore the welfare implications of this circumstance by comparing the adjustment of the economies and the area as a whole in response to terms-of-trade shocks under four monetary policy rules: fully optimal, optimal inflation targeting, HICP targeting and output gap stabilization.

Keywords: Optimal Monetary Policy, Currency Areas, Inflation Dynamics

JEL Classification: E52, E58

Suggested Citation

Benigno, Pierpaolo and Lopez-Salido, David, Inflation Persistence and Optimal Monetary Policy in the Euro Area (December 2002). ECB Working Paper No. 178; FRB International Finance Discussion Paper No. 749. Available at SSRN: https://ssrn.com/abstract=358180

Pierpaolo Benigno (Contact Author)

LUISS Guido Carli University

Viale Romania 32
Rome, Roma 00197
Italy

Einaudi Institute for Economics and Finance (EIEF) ( email )

Via Due Macelli, 73
Rome, 00187
Italy

David Lopez-Salido

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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