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The optimal rate of inflation with trending relative prices

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  • Alexander L. Wolman

Abstract

The relative prices of different categories of consumption goods have been trending over time. Assuming they are exogenous with respect to monetary policy, these trends imply that monetary policy cannot stabilize the prices of all consumption categories. If prices are sticky, monetary policy then must trade off relative price distortions within different categories of consumption. Optimally, more weight should be placed on stabilizing goods and services prices that are less flexible. Calibrating a simple sticky price model to U.S. data, we find that slight deflation is optimal, even absent transactions frictions leading to a demand for money. Optimality of deflation derives from the fact that relative prices have been trending up for services, whose nominal prices seem to be less flexible.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 09-02.

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Date of creation: 2009
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Handle: RePEc:fip:fedrwp:09-02

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Keywords: Inflation (Finance) ; Prices;

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  1. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  2. Jeremy Greenwood & Gokce Uysal, 2004. "New Goods and the Transition to a New Economy," NBER Working Papers 10793, National Bureau of Economic Research, Inc.
  3. Kevin X. D. Huang & Zheng Liu, 2003. "Inflation Targeting: What Inflation Rate to Target?," Emory Economics 0318, Department of Economics, Emory University (Atlanta).
  4. Charles T. Carlstrom & Timothy S. Fuerst & Fabio Ghironi, 2002. "Does It Matter (for Equilibrium Determinacy) What Price Index the Central Bank Targets?," Boston College Working Papers in Economics 533, Boston College Department of Economics, revised 07 Feb 2003.
  5. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers 2755, C.E.P.R. Discussion Papers.
  6. Loyo, Eduardo, 2002. "Imaginary money against sticky relative prices," European Economic Review, Elsevier, vol. 46(6), pages 1073-1092, June.
  7. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
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Cited by:
  1. Schmitt-Grohé, Stephanie & Uribe, Martín, 2012. "On quality bias and inflation targets," Journal of Monetary Economics, Elsevier, vol. 59(4), pages 393-400.
  2. Henning Weber, 2011. "Optimal inflation and firms' productivity dynamics," Kiel Working Papers 1685, Kiel Institute for the World Economy.
  3. Robert Amano & Kevin Moran & Stephen Murchison & Andrew Rennison, 2007. "Trend Inflation, Wage and Price Rigidities, and Welfare," Working Papers 07-42, Bank of Canada.
  4. Gerberding, Christina & Gerke, Rafael & Hammermann, Felix, 2012. "Price-level targeting when there is price-level drift," Journal of Macroeconomics, Elsevier, vol. 34(3), pages 757-768.

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