Optimal Monetary Policy with Non-homothetic Preferences

Cesar Blanco and Sebastian Diz
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Cesar Blanco: Newcastle University
Sebastian Diz: Central Bank of Paraguay

International Journal of Central Banking, 2025, vol. 21, issue 2, 309-350

Abstract: We study optimal monetary policy in a multisector model where preferences are non-homothetic. We find that a lower-than-one income elasticity in food demand, due to non-homotheticity, reduces the weight on food inflation in the optimal index that the monetary authority should target. The reasons are threefold. First, food price stabilization requires large deviations of output from the efficient level. Second, food demand becomes insensitive to monetary policy. Third, the low sectoral marginal propensity to consume implies that food price volatility has a reduced impact on aggregate demand. These results provide a rationale for targeting an index that excludes food inflation.

Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:ijc:ijcjou:y:2025:q:2:a:7

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