Should Central Banks Target Investment Prices?

Susanto Basu and Pierre De Leo

No 910, Boston College Working Papers in Economics from Boston College Department of Economics

Abstract: Central banks nearly always state explicit or implicit inflation targets in terms of consumer price inflation. If there are nominal rigidities in the pricing of both consumption and investment goods and if the shocks to the two sectors are not identical, then monetary policy cannot stabilize inflation and output gaps in both sectors. Thus, the central bank faces a tradeoff between targeting consumption price inflation and investment price inflation. In this setting, ignoring investment prices typically leads to substantial welfare losses because the intertemporal elasticity of substitution in investment is much higher than in consumption. In our calibrated model, consumer price targeting leads to welfare losses that are at least three times the loss under optimal policy. A simple rule that puts equal weight on stabilizing consumption and investment price inflation comes close to replicating the optimal policy. Thus, GDP deflator targeting is not a good approximation to optimal policy. A shift in monetary policy to targeting a weighted average of consumer and investment price inflation may produce significant welfare gains, although this would constitute a major change in current central banking practice.

Keywords: Inflation Targeting; Investment-Specific Technical Change; Investment Price Rigidity; Optimal Monetary Policy (search for similar items in EconPapers)
JEL-codes: E31 E32 E52 E58 (search for similar items in EconPapers)
Date: 2016-03-25, Revised 2017-05-04
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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Citations: View citations in EconPapers (3)

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