Taylor Rules with Headline Inflation: A Bad Idea

Rajeev Dhawan and Karsten Jeske
Working Paper 2007-14
July 2007

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Should a central bank accommodate energy price shocks? Should the central bank use core inflation or headline inflation with the volatile energy component in its Taylor rule? To answer these questions, we build a dynamic stochastic general equilibrium model with energy use, durable goods, and nominal rigidities to study the effects of an energy price shock and its impact on the macroeconomy when the central bank follows a Taylor rule. We then study how the economy performs under alternative parameterizations of the rule with different weights on headline and core inflation after an increase in the energy price. Our simulation results indicate that a central bank using core inflation in its Taylor rule does better than one using headline inflation because the output drop is less severe. In general, we show that the lower the weight on energy price inflation in the Taylor rule, the impact of an energy price increase on gross domestic product and inflation is also lower.

JEL classification: E32, Q43

Key words: energy prices, business cycles, durable goods, nominal rigidities, monetary transmission mechanism

The authors thank seminar participants at the Federal Reserve Bank of Atlanta for their helpful comments. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Karsten Jeske (contact author), Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8825, jeske100@gmail.com, or Rajeev Dhawan, Director, Economic Forecasting Center, J. Mack Robinson College of Business, Georgia State University, 35 Broad Street, Suite 200, Atlanta, GA 30303.

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.