In two papers, we have examined whether monetary policy rules should be specified in terms of consumer or output price inflation. In Leith and Wren-Lewis (2001) we found that this choice was important, particularly in response to exchange rate shocks. In Leith and Wren-Lewis (2009) we look at a two country model where PPP holds for consumer prices. We find that, if both countries target consumer prices, this will probably be destabilising, while targeting output prices will not. Kirsanova, Leith and Wren-Lewis (2006) also looks at a small open economy, and finds that instability can result from monetary policy rules based on consumer price inflation if those rules are aggressive.
Stability in a Fixed Exchange Rate Regime
Under fixed exchange rates when uncovered interest parity holds, nominal interest rates are fixed at overseas levels. If inflation is governed by a backward looking Phillips curve, this raises the possibility that the inflation process may be unstable. It might be thought that this instability is avoided by the impact of competitiveness on aggregate demand. However, in Kirsanova, Vines and Wren-Lewis (2005), we show that this is not the case. Competitiveness effects generate cyclicality, but they do not prevent unstable inflation processes: we observe explosive cycles. However, this instability can be avoided by using fiscal policy in a countercyclical manner. The paper also looks at mixed forward/backward Phillips curves.
Responding to Exchange Rate Misalignments
Periods in which real exchange rates persistently and significantly stray from levels implied by fundamentals seem endemic under floating exchange rates. In standard models these movements are represented as shocks to Uncovered Interest Parity or International Risk Sharing. In Leith and Wren-Lewis (2006) we examine what the optimal monetary response to such shocks would be in a model with traded and non-traded goods. We show how a social planner would respond to such shocks by maintaining levels of production in both sectors. However, under flexible prices a shock that leads to an exchange rate appreciation will increase the production of non-traded goods relative to traded goods. If we have price rigidity, policy can intervene to moderate this response. We compare an optimal policy (given welfare implied by the representative agent) to one under alternative policy regimes, including output price inflation targeting.
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