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The Optimal Rate of Inflation

In: Handbook of Monetary Economics

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  • Schmitt-Grohé, Stephanie
  • Uribe, Martín

Abstract

Observed inflation targets around the industrial world are concentrated at two percent per year. This chapter investigates the extent to which the observed magnitudes of inflation targets are consistent with the optimal rate of inflation predicted by leading theories of monetary non-neutrality. We find that consistently those theories imply that the optimal rate of inflation ranges from minus the real rate of interest to numbers insignificantly above zero. Furthermore, we argue that the zero bound on nominal interest rates does not represent an impediment for setting inflation targets near or below zero. Finally, we find that central banks should adjust their inflation targets upward by the size of the quality bias in measured inflation only if hedonic prices are more sticky than nonquality-adjusted prices.

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This chapter was published in:

  • Benjamin M. Friedman & Michael Woodford (ed.), 2010. "Handbook of Monetary Economics," Handbook of Monetary Economics, Elsevier, edition 1, volume 3, number 3, January.
    This item is provided by Elsevier in its series Handbook of Monetary Economics with number 3-13.

    Handle: RePEc:eee:monchp:3-13

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    Web page: http://www.elsevier.com/wps/find/bookseriesdescription.cws_home/BS_HE/description

    Related research

    Keywords: Downward Nominal Rigidities; Foreign Demand for Money; Friedman Rule; Quality Bias; Ramsey Policy; Sticky-Prices; Zero Bound;

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    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, December.
    2. Nicolini, Juan Pablo, 1998. "Tax evasion and the optimal inflation tax," Journal of Development Economics, Elsevier, vol. 55(1), pages 215-232, February.
    3. Peter J. Klenow & Oleksiy Kryvtsov, 2005. "State-Dependent or Time-Dependent Pricing: Does It Matter for Recent U.S. Inflation?," Working Papers 05-4, Bank of Canada.
    4. Adam, Klaus & Billi, Roberto M., 2006. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1877-1905, October.
    5. Stephanie Schmitt-Grohe & Martin Uribe, 2009. "On Quality Bias and Inflation Targets," NBER Working Papers 15505, National Bureau of Economic Research, Inc.
    6. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, MIT Press, vol. 123(4), pages 1415-1464, November.
    7. Michael Woodford & Pierpaolo Benigno, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," 2004 Meeting Papers 481, Society for Economic Dynamics.
    8. Schmitt-Grohé, Stephanie & Uribe, Martín, 2009. "Foreign Demand for Domestic Currency and the Optimal Rate of Inflation," CEPR Discussion Papers 7549, C.E.P.R. Discussion Papers.
    9. Tack Yun, 2005. "Optimal Monetary Policy with Relative Price Distortions," American Economic Review, American Economic Association, vol. 95(1), pages 89-109, March.
    10. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.
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    Cited by:
    1. Michael Woodford, 2010. "Optimal Monetary Stabilization Policy," Discussion Papers 0910-18, Columbia University, Department of Economics.
    2. Olivier Coibion & Yuriy Gorodnichenko & Johannes Wieland, 2010. "The Optimal Inflation Rate in New Keynesian Models," Working Papers 91, Department of Economics, College of William and Mary.
    3. Anderson, Gary S. & Kim, Jinill & Yun, Tack, 2010. "Using a projection method to analyze inflation bias in a micro-founded model," Journal of Economic Dynamics and Control, Elsevier, vol. 34(9), pages 1572-1581, September.
    4. Henning Weber, 2011. "Optimal inflation and firms' productivity dynamics," Kiel Working Papers 1685, Kiel Institute for the World Economy.
    5. Otmar Issing, 2011. "Lessons for monetary policy: what should the consensus be?," Globalization and Monetary Policy Institute Working Paper 81, Federal Reserve Bank of Dallas.
    6. Paul Pichler & Gerhard Sorger & Stefan Niemann, 2011. "Public debt, discretionary policy, and inflation persistence," 2011 Meeting Papers 887, Society for Economic Dynamics.
    7. Tao Peng, 2012. "A Note on the implementation of the Pareto efficient allocation in the Lagos-Wright model," Economics Bulletin, AccessEcon, vol. 32(1), pages 27-36.
    8. Bennett T. McCallum, 2011. "Should central banks raise their inflation targets? Some relevant issues," Economic Quarterly, Federal Reserve Bank of Richmond, issue 2Q, pages 111-131.
    9. Angelo Melino, 2011. "Moving Monetary Policy Forward: Why Small Steps - and a Lower Inflation Target - Make Sense for the Bank of Canada," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 319, January.
    10. Rhee, Hyuk Jae & Turdaliev, Nurlan, 2013. "Central bank transparency: Does it matter?," International Review of Economics & Finance, Elsevier, vol. 27(C), pages 183-197.
    11. Etienne B. Yehoue, 2012. "On Price Stability and Welfare," IMF Working Papers 12/189, International Monetary Fund.

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