Inflation and Social Welfare in a New Keynesian Model: The Case of Japan and the U.S

In this paper, we investigate the steady-state inflation rate that maximizes social welfare in a New Keynesian model. We calibrate the model on the Japanese and the U.S. economies, and we solve the model employing a computation method that addresses the non-linear dynamics associated with four major factors affecting the costs and benefits of inflation: (i) nominal price rigidity; (ii) money holdings; (iii) downward nominal wage rigidity (DNWR); and (iv) the zero lower bound of the nominal interest rates (ZLB). The calibrated model suggests the steady-state inflation rate that maximizes social welfare is close to two percent for both Japan and the U.S., though the main driver differs by country: the ZLB for Japan, but the DNWR for the U.S. In addition, around one percentage point absolute deviation from the close-to-two-percent rate induces only a minor change in social welfare. We also find that the lower-end of the range that is acceptable in terms of welfare losses is reduced when we introduce forward guidance in monetary policy through which private agents anticipate a prolonged zero interest rate once the ZLB binds. The estimates of the steady-state inflation rate are subject to a considerable margin of error due to parameter uncertainty in ZLB parameterization.