Should Central Banks Target Consumer Prices or the Exchange Rate?

Abstract

In this article we consider two arguments suggesting that monetary authorities in an open economy should target output price inflation and not consumer price inflation. The first suggests that output price inflation corresponds to the distortions caused by price rigidity. The second shows how policy rules involving consumer price inflation can induce instability because of the feedback from interest rates to consumer price inflation via the exchange rate. We examine both arguments in the context of an open economy which is subject to a range of shocks. We show that both arguments remain robust but that there is a case for including a terms of trade or real exchange rate gap term in the authorities’ welfare function alongside the output gap and output price inflation.

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