Optimal monetary policy with non-homothetic preferences

Cesar Blanco and Sebastian Diz

MPRA Paper from University Library of Munich, Germany

Abstract: This paper explores the optimal design of monetary policy in a multisector model where agents' preferences are non-homothetic. Non-homotheticity derives from the existence of a minimum consumption requirement for food, which households need to satisfy for subsistence. We find that the introduction of a minimum consumption requirement reduces the weight on food inflation in the optimal index that the monetary authority should target. We identify three motives for such prescription. First, non-homothetic preferences turn the stabilization of food inflation more costly, as it requires larger deviations of output from the efficient level. Second, proximity to the subsistence level turns the demand for food insensitive to monetary policy. Inflation in this sector thus becomes difficult to control. Third, non-homothetic preferences imply that households spend only a small share of any additional income on food. This means that prices in this sector have a reduced impact on aggregate consumption demand. Hence, responding to inflation in this sector becomes less relevant. Importantly, our results provide a rationale for targeting an index that excludes (or attaches a limited weight to) food inflation, a usual practice amongst central bankers.

Keywords: Inflation; Price Index; Monetary Policy (search for similar items in EconPapers)
JEL-codes: E31 E52 (search for similar items in EconPapers)
Date: 2021-04-26
New Economics Papers: this item is included in nep-cba, nep-cwa, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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