When does the cost channel pose a challenge to inflation targeting central banks? |
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| Institution: | 1. University of Essex, UK;2. Nova School of Business and Economics, Portugal;1. CREST, CNRS, Ecole Polytechnique, 5 avenue Le Chatelier, 91120 Palaiseau, France;2. CREST, 5 av. Le Chatelier, Palaiseau 91120, France;3. CREST, 5 avenue Le Chatelier, Palaiseau 91120, France;1. Department of Education, Hokkaido University of Education, 1-2 Hachimancho, Hakodate, Hokkaido, 040-8567, Japan;2. Department of Political Science and Economics, Takushoku University, 3-4-14 Kohinata, Bunkyo-ku, Tokyo, 112-8585, Japan;3. Research Institute for Policies on Pension & Aging, NBF Takanawa Building 4th Floor, 1-3-13 Takanawa, Minato-ku, Tokyo, 108-0074, Japan |
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| 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. |
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| Keywords: | Cost channel Taylor rule Determinacy Regime switching Nominal growth |
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