When does the cost channel pose a challenge to inflation targeting central banks?

A. Lee Smith

European Economic Review, 2016, vol. 89, issue C, 471-494

Abstract: In a sticky-price model where firms finance their production inputs, there is both a lower and an upper bound on the central bank's inflation response necessary to rule out the possibility of self-fulfilling inflation expectations. This paper shows that real wage rigidities decrease this upper bound, but coefficients in the range of those on the Taylor rule place the economy well within the determinacy region. However, when there is time-variation in the share of firms who finance their inputs (i.e. Markov-switching) then inflation targeting interest rate rules frequently result in indeterminacy, even if the central bank also targets output. Adding a nominal growth target to the policy rule can often alleviate this indeterminacy and therefore anchor inflation expectations.

Keywords: Cost channel; Taylor rule; Determinacy; Regime switching; Nominal growth (search for similar items in EconPapers)
JEL-codes: C62 E3 E4 E5 (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:89:y:2016:i:c:p:471-494

DOI: 10.1016/j.euroecorev.2016.09.002

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