What Measure of Inflation Should a Developing Country Central Bank Target?

IMF Working Papers, September 23, 2015

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In closed or open economy models with complete markets, targeting core inflation enables monetary policy to maximize welfare by replicating the flexible price equilibrium.
The paper analyzes this result for developing economies characterized by:
- a large proportion of households that are credit constrained, and
- a high share of food expenditures in total consumption expenditures.
An open economy model with incomplete financial markets is developed to show that headline inflation targeting improves welfare outcomes.
The optimal price index computed in the paper:
- includes a positive weight on food prices, and
- unlike headline inflation, assigns zero weight to import prices.

Model type: open economy model with incomplete financial markets.
Key mechanisms highlighted:
- Credit constraints among households alter the welfare implications of inflation-targeting rules derived under complete-market assumptions.
- High share of food in consumption leads to different optimal weighting of food prices in an objective price index.
Main comparative result:
- Under complete markets (closed or open economy), core inflation targeting maximizes welfare by replicating the flexible price equilibrium.
- Under incomplete financial markets relevant for developing economies, headline inflation targeting yields improved welfare outcomes relative to core inflation targeting.

Computed characteristics:
- Positive weight on food prices.
- Zero weight on import prices (distinguishing it from headline inflation).

For developing country central banks operating in environments with widespread credit constraints and high food expenditure shares, headline inflation targeting may be more welfare-improving than core inflation targeting derived from complete-market models.
The optimal targeting index for such economies should incorporate food-price movements while excluding import prices.