Optimal monetary policy responses to relative-price changes

An optimizing model, with a flexible-price sector and a sticky-price sector, is presented to analyze the effects of relative-price changes on inflation fluctuations. The relative price of the flexible-price good represents a shift parameter of the New Keynesian Phillips curve. The optimal monetary policy is to target sticky-price inflation, rather than a broad inflation measure. Although stabilizing the relative price around its efficient value is one of the appropriate goals of the central bank, stabilizing sticky-price inflation is sufficient for achieving this goal. An optimal monetary policy for a small open economy is also discussed. (C) 2001 Published by Elsevier Science B.V.