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The Optimal Rate of Inflation

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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 paper 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 are non-quality-adjusted prices.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7864.

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Date of creation: Jun 2010
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Handle: RePEc:cpr:ceprdp:7864

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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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  1. Adam, Klaus & Billi, Roberto M., 2004. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," CFS Working Paper Series 2004/13, Center for Financial Studies (CFS).
  2. Pierpaolo Benigno & Michael Woodford, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," NBER Working Papers 10838, National Bureau of Economic Research, Inc.
  3. Peter J. Klenow & Oleksiy Kryvtsov, 2007. "State-Dependent or Time-Dependent Pricing: Does It Matter for Recent U.S. Inflation?," Discussion Papers 07-007, Stanford Institute for Economic Policy Research.
  4. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, December.
  5. Schmitt-Grohé, Stephanie & Uribe, Martín, 2009. "On Quality Bias and Inflation Targets," CEPR Discussion Papers 7550, C.E.P.R. Discussion Papers.
  6. Stephanie Schmitt-Grohé & Martín Uribe, 2009. "Foreign Demand for Domestic Currency and the Optimal Rate of Inflation," NBER Working Papers 15494, National Bureau of Economic Research, Inc.
  7. 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.
  8. 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.
  9. Nicolini, Juan Pablo, 1998. "Tax evasion and the optimal inflation tax," Journal of Development Economics, Elsevier, vol. 55(1), pages 215-232, February.
  10. Tack Yun, 2005. "Optimal Monetary Policy with Relative Price Distortions," American Economic Review, American Economic Association, vol. 95(1), pages 89-109, March.
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Citations

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Cited by:
  1. Rhee, Hyuk Jae & Turdaliev, Nurlan, 2013. "Central bank transparency: Does it matter?," International Review of Economics & Finance, Elsevier, vol. 27(C), pages 183-197.
  2. Bennett T. McCallum, 2011. "Should Central Banks Raise their Inflation Targets? Some Relevant Issues," NBER Working Papers 17005, National Bureau of Economic Research, Inc.
  3. Gary S. Anderson & Jinill Kim & Tack Yun, 2010. "Using a projection method to analyze inflation bias in a micro-founded model," Finance and Economics Discussion Series 2010-18, Board of Governors of the Federal Reserve System (U.S.).
  4. 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.
  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. Etienne B. Yehoue, 2012. "On Price Stability and Welfare," IMF Working Papers 12/189, International Monetary Fund.
  7. Michael Woodford, 2010. "Optimal Monetary Stabilization Policy," Discussion Papers 0910-18, Columbia University, Department of Economics.
  8. Henning Weber, 2011. "Optimal inflation and firms' productivity dynamics," Kiel Working Papers 1685, Kiel Institute for the World Economy.
  9. Paul Pichler & Gerhard Sorger & Stefan Niemann, 2011. "Public debt, discretionary policy, and inflation persistence," 2011 Meeting Papers 887, Society for Economic Dynamics.
  10. 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.
  11. 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.

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