Sticky Wages, Incomplete Pass-Through and Inflation Targeting: What is the Right Index to Target?

This paper studies strict monetary policy rules in a small open economy with Inflation Targeting, incomplete pass-through and rigid nominal wages. The paper shows that, when nominal wages are fully flexible and pass-through is low to moderate, the monetary authority should target the Consumer Price Index (CPI) rather than the Domestic Price Index (DPI). When pass-through is high, an economy with high degrees of nominal wage rigidity and wage indexation should either target the CPI or fully stabilise nominal wages. These results suggest that, by committing to a common monetary policy in a common-currency area, some countries may not be following the right monetary policy rules.