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University of Hagen, Department of Economics, Germany and University of Hagen, Department of Economics, Germany. A first draft of this paper was written, when Helmut Wagner was a Visiting Scholar in the Research Department of the IMF.
The production technology is linear in work effort (see below).
The production technology can be explicitly written as y (z) = K–1h with h denoting the work effort of the representative household. Shocks K > 0 are therefore negative productivity shocks reducing the quantity of goods produced with a given labour input.
Devereux and Engel (2004) argue that prices of intermediate goods can be regarded as more flexible than prices of consumption goods. Moreover, empirical studies show that the degree of pass-though is by far higher for imported goods than for consumption goods (see Campa et al. (2005)).
Although work effort enters households’ utility function linearly (see equation (1)), households’ utility decreases in the volatility of work effort in the approximated utility function (18). This effect is based on Jensen’s inequality as pointed out by Sutherland (2004b).
This knife-edge result is based on our assumption of a unitary elasticity of substitution between home and foreign goods.
As stressed by Devereux and Engel (2004), the consideration of fixed-price and flex-price producers creates another source of inefficiency. In the face of stochastic productivity disturbances production of fixed- and flex-price producers will differ. While flex-price producers vary prices and thus ensure that their output remains on the efficiency frontier, fixed price producers are prevented from an optimal adjustment to shocks by price contracts.
Remember that global welfare depends only on the variance of the disutility of work effort (see equation (18)).
In contrast to our paper, however, Kollmann (2002) concentrates on Taylor rules. See also Taylor (1993) and Taylor (1999). Currently, there is a considerable debate in the literature about the merits of simple targeting versus simple instrument (Taylor type) rules. See Svensson (2004) and McCallum and Nelson (2004).
Rules are only considered in their strict form, i.e. policymakers are assumed to ignore other objectives.
Sutherland (2004a) shows that asymmetric regimes are welfare inferior to symmetric ones in a model where both economies are mirror images of each other as in our model.
This definition is similar to the definition of a specific targeting rule introduced by Svensson (2002). Svensson, however, reserves the term target for variables that enter the policymaker’s objective (loss) function.
Sutherland (2004a) stresses these rules can be alternatively formulated as feedback rules that follow
Results for υ = 0 are not shown because for complete flexibility of all prices output and work effort are completely exogenously determined.
Neither nominal income targeting nor monetary targeting as modelled here stabilize intermediate output directly. But by affecting final goods output monetary policy can impact intermediate goods output.
Further simulations not reported here show that the welfare losses associated with NIT and MT rise tremendously if
Moreover, nominal income targeting converges to monetary targeting for υ close to one.