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WHICH INFLATION TO TARGET? A SMALL OPEN ECONOMY WITH STICKY WAGES

Published online by Cambridge University Press:  24 May 2012

Alessia Campolmi
Alessia Campolmi*
Affiliation:
Central European University and Magyar Nemzeti Bank
*
Address correspondence to: Alessia Campolmi, Central European University and Magyar Nemzeti Bank; e-mail: [email protected]; URL: http://www.personal.ceu.hu/departs/personal/Alessia_Campolmi/.
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Abstract

There is common agreement on price inflation stabilization being one of the objectives of monetary policy. But, in an open economy, two alternative measures of inflation coexist: domestic inflation and consumer price inflation. Which of the two should be the target variable? Most of the new open economy macroeconomics (NOEM) literature suggests that the monetary authority should stabilize domestic inflation. This is in sharp contrast with the practice of many inflation-targeting central banks that are using consumer price index (CPI) inflation as target variable. The paper shows that the standard result in the NOEM literature is derived under the simplifying assumption of flexible wages. The inclusion of sticky wages in an otherwise standard small open economy model is shown to rationalize CPI inflation targeting. This conclusion is robust to changes in key parameters, including the trade elasticity.

Keywords

InflationOpen EconomySticky WagesOptimal Monetary Policy
Type
Articles
Information
Macroeconomic Dynamics , Volume 18 , Issue 1 , January 2014 , pp. 145 - 174
Copyright
Copyright © Cambridge University Press 2012 

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