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What price index should central banks target? An open economy analysis

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  • Matsumura, Misaki

Abstract

What price index should central banks target when economies are open and exposed to international price shocks? This paper derives the optimal price index by solving the Ramsey problem in a New Keynesian small open economy model with an arbitrary number of sectors. This approach improves on the existing theoretical benchmarks by (1) making an explicit distinction between the consumer price index (CPI) and the producer price index (PPI), (2) incorporating exogenous international price shocks, and (3) allowing different pricing regimes across sectors. Qualitatively, the analytical expression of the optimal price index suggests that popular indices, such as the core/headline CPI and the PPI, are suboptimal because they ignore the effect of volatile export price inflation on the trade surplus and the heterogeneity in price stickiness. Quantitatively, when a 35-sector model is applied to 40 countries, stabilizing the optimal price index yields significantly higher welfare than alternative indices.

Suggested Citation

  • Matsumura, Misaki, 2022. "What price index should central banks target? An open economy analysis," Journal of International Economics, Elsevier, vol. 135(C).
    • Handle: RePEc:eee:inecon:v:135:y:2022:i:c:s0022199621001343
    DOI: 10.1016/j.jinteco.2021.103554
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    1. Dietrich, Alexander M., 2023. "Consumption categories, household attention, and inflation expectations: Implications for optimal monetary policy," University of Tübingen Working Papers in Business and Economics 157, University of Tuebingen, Faculty of Economics and Social Sciences, School of Business and Economics.

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    More about this item

    Keywords

    Price index; Small open economy; Optimal monetary policy; Targeting;
    All these keywords.

    JEL classification:

    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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