FRB: Optimal Monetary Policy with Distinct Core and Headline Inflation Rates

International Finance Discussion Papers

Optimal Monetary Policy with Distinct Core and Headline Inflation Rates
Martin Bodenstein, Christopher J. Erceg, and Luca Guerrieri
2008-941 (August 2008)

Abstract: 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.

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

Related Material
Technical Appendix (186 KB PDF) The appendix shows how to derive the second order approximation to the welfare loss function.

Replication Codes (829 KB ZIP) A zip file that contains MATLAB programs to replicate the results reported in the paper. See file readme.txt for instructions.

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