Academic journal article Journal of Money, Credit & Banking

Inflation Persistence and Optimal Monetary Policy in the Euro Area

Academic journal article Journal of Money, Credit & Banking

Inflation Persistence and Optimal Monetary Policy in the Euro Area

Article excerpt

IN THIS PAPER we examine the idea that in the euro area monetary policy should be conducted so as to eliminate, or at least mitigate, the distortions in relative prices that might arise because of the differences in the degree of adjustment of inflation rates to terms of trade shocks (i.e. asymmetric shocks). This objective of policy is close to the principle under which a mandate of price stability has been delegated to the ECB. In fact, as stressed in the 1999 Bulletin of the ECB (1999), the main argument for price stability is that it improves the transparency of the relative price mechanism, thereby avoiding distortions and helping to ensure that the market allocates real resources efficiently both across uses and over time. In this paper, we will present a theoretical framework, which is supported by the empirical evidence, where we can explicitly address such an issue.

We formulate a two-region optimizing-agent model. In one region, sellers behave as in the standard Calvo (1983) model in which firms that are allowed to reset their prices take into account their expected discounted value of profits showing then a forward-looking behavior. In the other region, among the firms that are allowed to change their prices, a fraction follows a forward-looking behavior while the other fraction follows a rule of thumb showing a backward-looking behavior. In this region past inflation also plays a crucial role in understanding inflation dynamic. To calibrate our model, we estimate New Keynesian Phillips Curves for the five major countries of the euro area. We find evidence pointing out the existence of two different zones inside the euro area. There is one country (Germany) where we cannot reject that inflation has a significant forward-looking component. The other group of countries is formed by France, Italy, Spain, and to a lesser extent the Netherlands, where inflation dynamics are mixed by forward- and backward-looking components.

We then exploit the micro-foundations of our framework in order to provide a welfare criterion for the Central Bank in terms of the utility of the consumers. The policymaker seeks to stabilize the output gap as well as a weighted average of inflation rates in the area. Moreover, importance should be given to the deviation of the relative price between regions with respect to the natural level. Given the role of past inflation in understanding inflation persistence in the area, monetary policymakers should also stabilize the growth in the inflation rate in the region characterized by the hybrid model. Within this framework we analyze both the dynamic adjustment of the driving macroeconomic variables in the regions and area to terms-of-trade shocks, as well as the welfare implications of alternative monetary policy rules. We focus on four alternative policy rules: (1) fully optimal policy, (2) optimal inflation targeting policy, (3) Harmonized Index of Consumer Prices (HICP)-targeting, and (4) stabilization of the area output gap.

We show within our framework that, in principle, a quantitative target in terms of stabilization of the HICP does not succeed in eliminating the distortions in the relative price mechanism. We have proposed two policies that may perform better: the optimal inflation targeting policy (the inflation rate in the region with a combined higher degree of price rigidity and backward-looking behavior should receive higher weight), which generalizes that outlined in Benigno (2004), and the output-gap stabilization policy. Nevertheless, we argue that the applicability of these policies has pros and cons, making it not so straightforward to move from HICP-targeting to other forms of targets. In particular, the architects of the ECB have specified a broad target, HICP inflation less than 2%, so as to give flexibility to the monetary policymakers in conducting their policy. Around this target, policymakers can have the discretion that allows them to evaluate in an appropriate way the different sources of rigidity of the inflation rate, without necessarily disclosing them to the public. …

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