What measure of inflation should a developing country central bank target? |
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Institution: | 1. Banco de Mexico, Mexico;2. Universidad de Buenos Aires, Argentina;1. School of Economics, UNSW Business School, Gate 2, High Street, UNSW Sydney, NSW, 2052, Australia;2. Melbourne Institute of Applied Economic and Social Research, University of Melbourne, 3010, Victoria, Australia |
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Abstract: | In closed or open economy models with complete markets, targeting core inflation enables monetary policy to maximize welfare by replicating the flexible price equilibrium. We analyze this result in the context of developing economies, where a large proportion of households are credit constrained and the share of food expenditures in total consumption expenditures is high. We develop an open economy model with incomplete financial markets to show that headline inflation targeting improves welfare outcomes. We also compute the optimal price index, which includes a positive weight on food prices but, unlike headline inflation, assigns zero weight to import prices. |
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Keywords: | Inflation targeting Monetary policy framework Core inflation Headline inflation Financial frictions |
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