Inefficient shocks and optimal monetary policy

Abstract

Real disturbances that lead to trade-offs between inflation and output gap stabilization have not been studied much in the context of monetary policy settings in emerging markets and developing economies (EMDEs). We identify market price support present in the agriculture sectors of the EMDEs as inefficient shocks that lead to such trade-offs. Using a three-sector new Keynesian dynamic stochastic general equilibrium model, we show trade-offs between core-inflation and output gap stabilization under discretionary and commitment policies. This result departs from the popular viewpoint, stating that the strict core-inflation targeting is an optimal monetary policy for EMDEs susceptible to relative price changes.