Working Paper: NBER ID: w21388
Authors: Rahul Anand; Eswar Prasad; Boyang Zhang
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.
Keywords: inflation targeting; developing economies; headline inflation; core inflation; welfare outcomes
JEL Codes: E31; E52; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| targeting headline inflation (E31) | improved welfare outcomes (I38) |
| targeting core inflation (E31) | does not stabilize output (C62) |
| financial frictions (G19) | different consumption responses to monetary policy changes (E21) |
| targeting headline inflation (E31) | better manage aggregate demand (E19) |
| targeting headline inflation (E31) | stabilize output (E63) |
| financial frictions (G19) | break comovement between inflation and output (E31) |
| stabilizing core inflation (E31) | does not stabilize output gap (E63) |
| targeting broader measure of inflation (E31) | improved welfare outcomes (I38) |