The Welfare Implications of Inflation versus Price-Level Targeting in a Two-Sector, Small Open Economy

Abstract

The authors analyze the welfare implications of simple monetary policy rules in the context of an estimated model of a small open economy for Canada with traded and non-traded goods, and with sticky prices and wages. They find statistically significant heterogeneity in the degree of price rigidity across sectors. They also find welfare gains in targeting only the non-traded-goods inflation, since prices are found to be more sticky in this production sector, but those gains come at the cost of substantially increased aggregate volatility. The authors look for the welfare-maximizing specification of an interest rate reaction function that allows for a specific price-level target. They find, however, that, overall, the higher welfare is achieved, given the estimated model for the Canadian economy, with a strict inflation-targeting rule where the central bank reacts to the next period's expected deviation from the inflation target and does not target the output gap.Economic models; Exchange rates; Inflation targets