A quantitative analysis of cost-push shocks and optimal inflation volatility

Abstract

This article presents a quantitative analysis of optimal inflation volatility in a simple sticky-price general equilibrium model subject to both supply and cost-push shocks. It is found that optimal policy implies a relatively small degree of inflation volatility even when cost-push shocks are the dominant source of economic disturbance. In addition, it is found that optimal policy generates only a very small welfare gain when compared to strict inflation targeting.

Notes

¹ Woodford (2004) briefly considers the optimal volatility of inflation with cost-push shocks and shows that, for one calibration of a simple model, the inflation volatility implied by an optimal response to cost-push shocks is relatively low. This observation is, however, for a single parameter combination. It is also for a special case of the model where welfare is approximated around an optimal steady state. We consider a wider set of parameter values. In addition, we analyze the more general case where steady state output is not at its first-best level.

 ² We use the term ‘restricted Taylor rule’ to distinguish our rule from the usual form of the Taylor rule, which usually includes both an inflation feedback term and an output feedback term.

 ³ See Benigno and Woodford (2005) for a definition of the welfare-relevant ‘output gap’.