Inflation Persistence, Backward-Looking Firms, and Monetary Policy in an Input-Output Economy

Abstract

This paper studies the implications of inflation persistence (generated by backward-looking price setters) for monetary policy in a New Keynesian 'input-output' model--a model with sticky prices both in intermediate and final goods sectors. Optimal policy under commitment depends on the degree of inflation persistence in both sectors. Under discretion, speed-limit targeting--targeting the change in the output gap--outperforms price-level and inflation targeting in the presence of inflation persistence. If inflation persistence is low in the intermediate goods sector, price-level targeting outperforms inflation targeting despite high inflation persistence in the final goods sector.