Working Paper: NBER ID: w26602
Authors: Shangjin Wei; Yinxi Xie
Abstract: We study the implications of global supply chains for the design of monetary policy, using a small-open economy New Keynesian model with multiple stages of production. Within the family of simple monetary policy rules with commitment, a rule that targets separate producer price inflation at different production stages, in addition to output gap and real exchange rate, is found to deliver a higher welfare level than alternative policy rules. As an economy becomes more open, measured by the export share, the optimal weight on the upstream inflation rises relative to that on the final stage inflation. If we have to choose among aggregate price indicators, targeting PPI inflation yields a smaller welfare loss than targeting CPI inflation alone. As the production chain becomes longer, the optimal weight on PPI inflation in the policy rule that targets both PPI and CPI inflation will also rise. A trade cost shock such as a rise in the import tariff can alter the optimal weights on different inflation variables.
Keywords: Monetary Policy; Global Supply Chains; New Keynesian Model
JEL Codes: E52; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| As an economy becomes more open (measured by the export share) (F43) | The optimal weight on upstream inflation rises relative to that on final stage inflation (E31) |
| Increased trade frictions (such as an increase in import tariffs) (F19) | Alters the optimal weights on different inflation variables (E31) |
| Increased trade frictions (F19) | Direct welfare loss associated with increased trade frictions (F69) |
| Trade costs (F19) | Optimal monetary policy design (E61) |