What Measure of Inflation Should a Developing Country Central Bank Target?

Rahul Anand, Eswar Prasad, Boyang Zhang
2015 IMF Working Papers  
8 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
more » ... re 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. Most central banks view low and stable inflation as a primary, if not dominant, objective 2 of monetary policy. In the existing literature, the choice of price index to target has been 3 guided by the idea that inflation is a monetary phenomenon. Core inflation (excluding 4 food, energy, and other volatile components from headline CPI) has been viewed as the 5 most appropriate measure of inflation since fluctuations in food and energy prices represent 6 supply shocks and are non-monetary in nature (Wynne, 2008) . Moreover, since these shocks 7 are transitory, highly volatile, and do not reflect changes in the underlying rate of inflation, 8 they should not be a part of the targeted price index (Mishkin, 2007 (Mishkin, , 2008 . 9 Previous authors have used models with price and/or wage stickiness to show that tar-10 geting core inflation maximizes welfare. Existing models have looked at complete market 11 settings where price stickiness is the only distortion (besides monopoly power). Infrequent 12 price adjustments cause mark-ups to fluctuate and also distort relative prices. In order to 13 restore the flexible price equilibrium, central banks should try to minimize these fluctuations 14 by targeting sticky prices King, 1997, 2001). 15 Using a New Keynesian model, Aoki (2001) demonstrates that targeting inflation in the 16 sticky price sector leads to macroeconomic stability and welfare maximization. Targeting 17 core inflation is equivalent to stabilizing the aggregate output gap as output and inflation 18 move in the same direction under complete markets. Benigno (2004) argues that in a common 19 currency area the central bank should target an index that gives higher weight to inflation in 20 regions with a higher degree of nominal rigidity, effectively ignoring exchange rate and com-21 modity price fluctuations. In a more general multi-sector setting, Mankiw and Reis (2003) 22 show that, in order to improve the stability of economic activity, the targeted "stability" 23 price index should put more weight on sectors that have sluggish price adjustment, are more 24 procyclical, and have a smaller weight in the consumer price index. 25 The results from the prior literature generally rely on the assumption that markets are 26 complete (allowing households to fully insure against idiosyncratic risks). The central bank 1 then only needs to tackle the distortions created by price stickiness. However, in developing 2 economies, a substantial fraction of agents are unable to smooth their consumption in a 3 manner consistent with the permanent income hypothesis. Moreover, developing economies 4 have other structural differences from advanced economies, including the relatively high share 5 of food in household consumption expenditures. 6 In this paper, we provide an analytical framework for determining the optimal price 7 index for developing economy central banks to target. We make three main contributions. 8 First, we generalize the results of Aoki (2001) and Benigno (2004) by developing a model 9 that encompasses their frameworks. Second, we show that incomplete financial markets and 10 other characteristics of developing economies substantially alter the key results. Third, we 11 derive optimal price indexes and compare them with feasible rules such as headline inflation 12 targeting that also improve welfare relative to core inflation targeting but are easier for 13 central banks to communicate and implement. 14 Our model has three sectors to make it more representative of the structures of developing 15 economies. First, the food (or informal) sector, which comprises a large fraction of the 16 economy and where prices are flexible. Workers in this sector live hand-to-mouth, i.e., they 17 have no access to credit markets and simply consume their current labor income. Second, 18 the sticky price (or formal) sector that is subject to productivity shocks and mark-up shocks, 19 and where workers do have access to credit markets. Third, a sector that is open to foreign 20 trade and where prices are flexible but also highly volatile. This sector, which proxies for 21 the commodity-producing sector, faces large external shocks. 22 Financial frictions that result in consumers being credit constrained have not received 23 much attention in models of inflation targeting. When markets are not complete and agents 24 differ in their ability to smooth consumption, their welfare depends on the nature of id-25 iosyncratic shocks. Thus, this model also allows us to analyze the welfare distribution under 26 alternative inflation targeting rules. Under incomplete markets, household income, which is 1 influenced by the nature of shocks and the price elasticity of the demand for goods, matters 2 for consumption choices. For instance, a negative productivity shock to a good with a low 3 price elasticity of demand could increase the income of net sellers of that good and raise the 4 expenditure of net buyers of that good. 5
doi:10.5089/9781513572574.001 fatcat:cvcruerabnbc3f2hsmpnn2oyfi