Inflation Targeting: What Inflation Rate to Target?

Posted: 20 Sep 2004

See all articles by Kevin X. D. Huang

Kevin X. D. Huang

Federal Reserve Bank of Philadelphia; Vanderbilt University - College of Arts and Science - Department of Economics

Zheng Liu

Federal Reserve Banks - Federal Reserve Bank of San Francisco

Abstract

In an economy with nominal rigidities in both an intermediate good sector and a finished good sector, and thus with a natural distinction between CPI and PPI inflation rates, a benevolent central bank faces a tradeoff between stabilizing the two measures of inflation: a final output gap, and unique to our model, a real marginal cost gap in the intermediate sector, so that optimal monetary policy is second-best. We discuss how to implement the optimal policy with minimal information requirement and evaluate the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities. A main finding is that a simple hybrid rule under which the short-term interest rate responds to CPI inflation and PPI inflation results in a welfare level close to the optimum, whereas policy rules that ignore PPI inflation or PPI sector shocks can result in significant welfare losses.

Keywords: Inflation targeting, CPI, PPI, Optimal monetary policy, Implementation, Welfare

JEL Classification: E31, E32, E52

Suggested Citation

Huang, Kevin X. D. and Liu, Zheng, Inflation Targeting: What Inflation Rate to Target?. Journal of Monetary Economics, Vol. 52, No. 8, pp. 1435-1462, November 2005 . Available at SSRN: https://ssrn.com/abstract=578881

Kevin X. D. Huang (Contact Author)

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Vanderbilt University - College of Arts and Science - Department of Economics ( email )

Box 1819 Station B
Nashville, TN 37235
United States

Zheng Liu

Federal Reserve Banks - Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

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