What price index should central banks target? An open economy analysis

Abstract

What price index should central banks target when economies are open and exposed to international price shocks? This paper derives the optimal price index by solving the Ramsey problem in a New Keynesian small open economy model with an arbitrary number of sectors. This approach improves on the existing theoretical benchmarks by (1) making an explicit distinction between the consumer price index (CPI) and the producer price index (PPI), (2) incorporating exogenous international price shocks, and (3) allowing different pricing regimes across sectors. Qualitatively, the analytical expression of the optimal price index suggests that popular indices, such as the core/headline CPI and the PPI, are suboptimal because they ignore the effect of volatile export price inflation on the trade surplus and the heterogeneity in price stickiness. Quantitatively, when a 35-sector model is applied to 40 countries, stabilizing the optimal price index yields significantly higher welfare than alternative indices.