Oil Price Shocks and Inflation Targeting in China

ABSTRACT We develop a small open economy DSGE-based New Keynesian model incorporating the demand for oil, to focus on whether the PBoC targets core inflation or headline inflation including oil price inflation, and investigating the macroeconomic effect of oil price shocks. Based on both counterfactual simulations and welfare evaluations, our results indicate that targeting both core inflation and non-core inflation are inferior to the one purely pegged to core inflation, suggesting the central bank should target core inflation instead of headline inflation. Our paper contributes to a growing literature on monetary policy in China and other emerging market economies.