Abstract
In this paper, we use the generalized Taylor economy ( GTE) framework to examine the optimal choice of inflation index. In this otherwise standard dynamic stochastic general equilibrium (DSGE) model, there can be many sectors, each with a different contract length. In the GTE framework with an empirically relevant contract structure, a simple rule under which the interest rate responds to economy-wide inflation gives a welfare outcome nearly identical to the optimal policy. This finding suggests that it may not be necessary for a well-designed monetary policy to respond to sector-specific inflations.
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