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Optimal monetary policy under low trend inflation

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  • Guido Ascari

    ()
    (University of Pavia)

  • Tiziano Ropele

    ()
    (Bank of Italy)

Abstract

In the monetary policy literature it is commonly assumed that trend inflation is zero, despite overwhelming evidence that zero inflation is neither empirically relevant nor a practical objective for central bank policy. We therefore extend the standard New Keynesian model to allow for positive trend inflation, showing that even low trend inflation has strong effects on optimal monetary policy and the dynamics of inflation, output, and interest rates. Under discretion, the efficient policy deteriorates and there is no guarantee of determinacy. Even with commitment, targeting non-zero trend inflation leads to substantial welfare losses. Our results serve as a warning against indiscriminate use of models assuming zero trend inflation.

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Bibliographic Info

Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 647.

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Date of creation: Nov 2007
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Handle: RePEc:bdi:wptemi:td_647_07

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Keywords: Optimal monetary policy; trend inflation;

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  1. Woodford, Michael, 2000. "Optimal Monetary Policy Inertia," Seminar Papers 666, Stockholm University, Institute for International Economic Studies.
  2. Stepahnie Schmitt-Grohé & Martín Uribe, 2007. "Optimal Inflation Stabilization in a Medium-Scale Macroeconomic Model," Central Banking, Analysis, and Economic Policies Book Series, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 5, pages 125-186 Central Bank of Chile.
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  5. Ascari, Guido, 2003. "Staggered prices and trend inflation: some nuisances," Research Discussion Papers 27/2003, Bank of Finland.
  6. Marvin Goodfriend & Robert G. King, 2001. "The case for price stability," Working Paper 01-02, Federal Reserve Bank of Richmond.
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  8. Schmitt-Grohe, Stephanie & Uribe, Martin, 2007. "Optimal simple and implementable monetary and fiscal rules," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1702-1725, September.
  9. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper 0107, Federal Reserve Bank of Cleveland.
  10. Söderlind, Paul, 1998. "Solution and Estimation of RE Macromodels with Optimal Policy," Working Paper Series in Economics and Finance 256, Stockholm School of Economics.
  11. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
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