Which inflation to target? A small open economy with sticky wages indexed to past inflation

Alessia Campolmi

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: In a closed economy context there is common agreement on price inflation stabilization being one of the objects of monetary policy. Moving to an open economy context gives rise to the coexistence of two measures of inflation: domestic inflation (DI) and consumer price inflation (CPI). Which one of the two measures should be the target variable? This is the question addressed in this paper. In particular, I use a small open economy model to show that once sticky wages indexed to past CPI inflation are introduced, a complete inward looking monetary policy is no more optimal. I first, derive a loss function from a second order approximation of the utility function and then, I compute the fully optimal monetary policy under commitment. Then, I use the optimal monetary policy as a benchmark to compare the performance of different monetary policy rules. The main result is that once a positive degree of indexation is introduced in the model the rule performing better (among the Taylor type rules considered) is the one targeting wage inflation and CPI inflation. Moreover this rule delivers results very close to the one obtained under the fully optimal monetary policy with commitment.

Keywords: Inflation; open economy; sticky wages; indexation (search for similar items in EconPapers)
JEL-codes: E12 E52 (search for similar items in EconPapers)
Date: 2006-03
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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Working Paper: Which inflation to target? A small open economy with sticky wages indexed to past inflation (2005)
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