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The Optimal Inflation Rate in New Keynesian Models

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  • Olivier Coibion

    () (Department of Economics, College of William and Mary)

  • Yuriy Gorodnichenko

    () (Department of Economics, University of California, Berkeley)

  • Johannes Wieland

    () (Department of Economics, niversity of California, Berkeley)

Abstract

We study the effects of positive steady-state inflation in New Keynesian models subject to the zero bound on interest rates. We derive the utility-based welfare loss function taking into account the effects of positive steady-state inflation and show that steady-state inflation affects welfare through three distinct channels: steady-state effects, the magnitude of the coefficients in the utility-function approximation, and the dynamics of the model. We solve for the optimal level of inflation in the model and find that, for plausible calibrations, the optimal inflation rate is low, less than two percent, even after considering a variety of extensions, including price indexation, endogenous price stickiness, capital formation, model uncertainty, and downward nominal wage rigidities. On the normative side, price level targeting delivers large welfare gains and a very low optimal inflation rate consistent with price stability.

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Bibliographic Info

Paper provided by Department of Economics, College of William and Mary in its series Working Papers with number 91.

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Length: 66 pages
Date of creation: 15 Jun 2010
Date of revision:
Handle: RePEc:cwm:wpaper:91

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Keywords: Optimal inflation; New Keynesian; zero bound; price level targeting;

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Citations

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Cited by:
  1. Sergio A. Lago Alves, 2012. "Trend Inflation and the Unemployment Volatility Puzzle," Working Papers Series 277, Central Bank of Brazil, Research Department.
  2. 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.
  3. Guido Ascari & Anna Florio, 2012. "Transparency, Expectations Anchoring and the Inflation Target," DEM Working Papers Series 022, University of Pavia, Department of Economics and Management.
  4. Ahrens, Steffen & Snower, Dennis J., 2012. "Envy, Guilt, and the Phillips Curve," CEPR Discussion Papers 8796, C.E.P.R. Discussion Papers.
  5. Roman Horvath & Jakub Mateju, 2010. "How Are Inflation Targets Set?," CERGE-EI Working Papers wp426, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  6. Hatcher, Michael C., 2011. "Inflation versus price-level targeting and the zero lower bound: Stochastic simulations from the Smets-Wouters US model," Cardiff Economics Working Papers E2011/24, Cardiff University, Cardiff Business School, Economics Section.
  7. Taisuke Nakata, 2012. "Optimal Fiscal and Monetary Policy with Occasionally Binding Zero Bound Constraints," 2012 Meeting Papers 181, Society for Economic Dynamics.
  8. Levine, Paul & Pearlman, Joseph, 2011. "Computation of LQ Approximations to Optimal Policy Problems in Different Information Settings under Zero Lower Bound Constraints," Dynare Working Papers 10, CEPREMAP.
  9. Jiri Bohm & Jan Filacek & Ivana Kubicova & Romana Zamazalova, 2011. "Price-Level Targeting - A Real Alternative to Inflation Targeting?," Research and Policy Notes 2011/01, Czech National Bank, Research Department.
  10. Olivier Coibion & Yuriy Gorodnichenko & Gee Hee Hong, 2012. "The Cyclicality of Sales, Regular and Effective Prices: Business Cycle and Policy Implications," IMF Working Papers 12/207, International Monetary Fund.
  11. William T. Gavin & Benjamin D. Keen & Michael R. Pakko, 2012. "Taylor-type rules and total factor productivity," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 41-64.
  12. Henning Weber, 2011. "Optimal inflation and firms' productivity dynamics," Kiel Working Papers 1685, Kiel Institute for the World Economy.

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