Inefficient Shocks and Optimal Monetary Policy

Abstract

The importance of trade-offs between inflation and output gap stabilization for monetary policy evaluation is well known. Real disturbances in the economy which lead to such trade-offs, however, have not been studied much in the context of monetary policy setting in emerging market and developing economies (EMDEs). We identify market price support present in the agriculture sectors of the EMDEs as a real disturbance leading to such trade-offs. Using a three-sector NK-DSGE model built in Ghate, Gupta, Mallick (2018), featuring food procurement policy in the Indian economy, we derive welfare loss function and characterize optimal monetary policy under discretion and commitment. We show that under both discretionary and commitment policy, trade-offs exist between core-inflation and output gap stabilization, and between headline inflation and output gap stabilization. This result departs from the existing popular view that strict core-inflation targeting is the optimal monetary policy for developing countries susceptible to sectoral relative-price changes. We also compare the response of the economy to a positive procurement shock and a negative productivity shock under different monetary policy rules. It is observed that an optimal simple rule with sectoral terms of trade/ relative price gaps improves welfare outcomes significantly.