Price level versus inflation rate targets in an open economy with overlapping wage contracts

Eric Hansen

No 96-01, Pacific Basin Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: The standard result in models of sticky prices is that an inflation rate target is better than a price level target at minimizing the variance of real output. This paper provides a contradictory result: a price level target may be preferred in an economy that is characterized by flexible prices in one sector and sticky prices in another sector. An example is a highly open economy that has flexible prices in the tradeable goods sector and sticky prices (due to Taylor-type overlapping wage contracts) in the non-tradeable goods sector. The robustness of these results is confirmed for variants of the model where wage contracts are based on relative real wages (following Fuhrer/Moore (1995) and when monetary policy has a one-period implementation lag relative to wage setters. The paper discusses the implications of the result in the light of New Zealand's current monetary policy framework.

Keywords: Inflation (Finance); Prices (search for similar items in EconPapers)
Date: 1996
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