August 2008

Optimal Monetary Policy with Distinct Core and Headline Inflation Rates

Martin Bodenstein, Christopher J. Erceg, and Luca Guerrieri


In a stylized DSGE model with an energy sector, the optimal policy response to an adverse energy supply shock implies a rise in core inflation, a larger rise in headline inflation, and a decline in wage inflation. The optimal policy is well-approximated by policies that stabilize the output gap, but also by a wide array of "dual mandate" policies that are not overly aggressive in stabilizing core inflation. Finally, policies that react to a forecast of headline inflation following a temporary energy shock imply markedly different effects than policies that react to a forecast of core, with the former inducing greater volatility in core inflation and the output gap.

Related Materials: Technical Appendix (PDF), The appendix shows how to derive the second order approximation to the welfare loss function; Replication Codes (ZIP), A zip file that contains MATLAB programs to replicate the results reported in the paper. See file readme.txt for instructions.

Full paper (screen reader version)

Keywords: Energy-price shocks, monetary policy tradeoffs, DSGE models

PDF: Full Paper

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Last Update: October 19, 2020