Understanding Inflation: Implications for Monetary Policy

Stephen G. Cecchetti, Erica L. Groshen

NBER Working Paper No. 7482
Issued in January 2000
NBER Program(s):Monetary Economics

This paper discusses how optimal monetary policy is affected by differences in the combination of shocks an economy experiences and the rigidities it exhibits. Without both nominal rigidities and economic shocks, monetary policy would be irrelevant. Recognizing this, policymakers increasingly incorporate the understanding gained from new research on rigidities and shocks into both their policy actions and the design of monetary institutions. Specifically, shocks can be predominantly real, affecting relative prices, or primarily nominal, moving the general price level. They may also be big or small, frequent or rare. Similarly, some nominal rigidities are symmetrical, affecting both upward and downward movements equally, while others are asymmetrical, restricting decreases more than increases. After reviewing major trends in the conduct of monetary policy, we describe how the growing theoretical and empirical literature on shocks and rigidities informs three crucial dimensions of monetary policymaking. First, we discuss why trimmed means provide the best measure of core inflation. Second, we outline how rigidities impede policymakers' ability to control inflation. And third, we describe how alternative shock/rigidity combinations create inflation's grease (whereby it improves economic efficiency by speeding adjustment) and sand effects (whereby it distorts price signals) with their contrasting implications for the optimal level of inflation. We conclude by considering some key implications for monetary policy.

download in pdf format
   (762 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w7482

Published: Dreze, Jacques H. (ed.) Advances in Macroeconomics, Proceedings of the Twelfth World Congress of the International Economic Association. London: Macmillan, Ltd., 2001.

Users who downloaded this paper also downloaded* these:
Giannitsarou and Scott w12654 Inflation Implications of Rising Government Debt
Hall Introduction to "Inflation: Causes and Effects"
Bernanke and Mishkin w5893 Inflation Targeting: A New Framework for Monetary Policy?
Friedman w8057 Monetary Policy
Bernanke and Woodford w6157 Inflation Forecasts and Monetary Policy
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us