Research Discussion Papers, Bank of Finland
No 12/2003:
Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables
Alfred V. Guender
Abstract: In open economy, a choice can be made between two measures
of inflation for use as a target variable: CPI inflation or domestic
inflation. This paper considers flexible and strict inflation targeting
strategies and explores the circumstances under which a domestic inflation
target is preferred to a CPI inflation target. This is done from the
perspectives of the central bank and society as a whole.
The
quantitative results of this paper indicate that under suitable conditions
the temporal properties of stochastic disturbances are instrumental in
determining which inflation target is preferred. The choice of target
variable from society’s viewpoint coincides almost perfectly with the
choice of the central bank if the utility of the representative household
serves as the welfare criterion for society.
If qualitative aspects
matter in the choice inflation target, then the role of temporal properties
of the stochastic disturbances becomes less prominent.
Policy
conclusions are drawn with the help of a forward-looking model for a small
open economy. This model has proper micro-foundations and exhibits two
important features. First, the degree of openness affects the parameters of
the IS relation and, second, under domestic inflation targeting, the
existence of a direct exchange rate channel in the Phillips Curve impairs
the perfect stabilising properties of monetary policy in the presence of
demand-side disturbances.
Keywords: monetary policy; inflation target; (follow links to similar papers)
JEL-Codes: E52; F41; (follow links to similar papers)
58 pages, May 12, 2003
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