Simple Inflation Targeting: an Acceptable Second Best?

Abstract

Departing from the long-asked question - what inflation index should the central bank target?- we ask another: is there an acceptable second-best inflation index that the central bank can target with ease but without much welfare losses? We develop a multi-sector new-Keynesian model to assess the performance of our candidate inflation index, which is simply a weighted average of the sectoral inflations with weights set to equal the sector size. We propose two forces under which the welfare gap between the aforementioned inflation targeting scheme and the optimal inflation targeting greatly reduces. (i) Under sector-wide labor market assumption, the real distortions from the sectoral inflations are reduced. (ii) Under imperfect risk-sharing assumption, a new source of welfare appears, which results in more stabilized sectoral inflations. We claim that under these two scenarios, our target inflation index becomes an acceptable second-best. To do so, we explore why and by how much these two assumptions affect the welfare gap between the two target inflation index we consider.