Inflation Targeting: What Inflation to Target?

By Kevin X.D. Huang and Zheng Liu
November 2003, Last Revised February 2004
RWP 03-10
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

      This paper derives a central bank's objective function and optimal policy rule for an economy with both CPI and PPI inflation rates.  It implements constrained-optimal policy rules with minimal information requirement, and evaluates the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities.  One of the main findings is that monetary policy that ignores PPI inflation rate or PPI sector shocks can result in significant welfare loss. 

Keywords: Inflation targeting; CPI; PPI; Optimal monetary policy; Implementation; Welfare

JEL Codes: E31, E32, E52

Kevin Huang is a senior economist at the Federal Reserve Bank of Kansas City. Zheng Liu is an assistant professor in the Department of Economics at Emory University. The authors are grateful to Ben Bernanke, V.V. Chari, Todd Clark, Mike Dotsey, Mark Gertler, Chris Gust, Bob King, Sharon Kozicki, John Leahy, Andy Levin, Tom Sargent, Mike Woodford, and seminar participants at the 2003 Federal Reserve System Committee Meeting on Macroeconomics, the Federal Reserve Bank of Kansas City, the 2003 Midwest Macroeconomics Meeting, the 2003 Missouri Economic Conference, the 2003 Annual Meeting of the Society for Economic Dynamics, and the 2004 Annual Meeting of the American Economic Association  for helpful conversations and comments. The views expressed are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Huang e-mail:  kevin.huang@kc.frb.org
Liu e-mail:  zliu5@emory.edu

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