Price-setting heterogeneity and robust monetary policy in a two-sector DSGE model of a small open economy

Abstract

The choice between targeting headline and core inflation is crucial in times of large supply shocks. We investigate this issue in a multi-sector dynamic stochastic general equilibrium (DSGE) model of a small open economy with price-setting heterogeneity in two sectors: the production of food and energy goods and the remaining goods and services. In this framework, we determine optimal monetary policy rules robust to uncertainty in the economic environment. To illustrate the application, we estimate the model on Polish data and show that reacting to core inflation is more welfare improving than headline inflation targeting; however, the choice between the headline and core inflation rules depends on country-specific factors. These factors include the sectoral degree of openness, supply and demand shocks structure, the share of food and energy in the consumption bundle, and the level of competitiveness. Finally, we propose a robust price index and show that the optimal weight assigned to core inflation is higher than when parameter uncertainty is neglected.