Input-output connections between sectors and optimal monetary policy. NBB Working Paper 166, June 2009

This paper considers the monetary policy implications of a model that features input-output connections between stages of production, so that a distinction between CPI inflation and PPI inflation arises. More specifically, this paper addresses the policy conclusion by K. Huang and Z. Liu [2005, "Inflation targeting: What inflation rate to target", Journal of Monetary Economics 52], which states that central banks should use an optimal inflation index that gives substantial weight to stabilising both CPI and PPI. This paper argues that these authors' findings rely on the assumption that producer prices are as sticky as consumer prices and it also shows that, once empirically relevant frequencies of price adjustment are used to calibrate the model, CPI inflation receives substantial weight in the optimal inflation index. Moreover, this rule is remarkably robust to uncertainty regarding the model parameters, whereas the policy rule proposed by Huang and Liu can result in heavy welfare losses