Economic Stability and the Choice of the Target Inflation Index

Abstract

This paper relates the Central Bank's choice of the target inflation index to expected economic stability in a small open economy that pursues inflation targeting. The analysis is set up in a New Keynesian model that allows for optimal monetary policy in presence of model uncertainty and exogenous shocks. The paper shows that for most of the macrovariables targeting the domestic price index instead of the CPI implies considerably more expected economic stability. When policy makers consider model uncertainty in the design of the optimal policy, the difference in the indexes' performance is sharpened allowing more informed decisions on their convenience.