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On Price Stability and Welfare

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  • Etienne B. Yehoue
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    Abstract

    The financial crisis in the advanced countries that began in 2007 has led central bankers to adopt unconventional policy measures as policy interest rates neared the zero bound. One suggestion (Blanchard, Dell’Ariccia, and Mauro, 2010) has been to raise inflation targets to provide more room for policy rate easing during crises. This paper addresses a different issue: the relationship between inflation and welfare. The literature is surveyed and a model is developed. A key conclusion is that an increase in inflation targets gives rise to additional welfare costs, even after the extra room to maneuver above the zero lower bound for nominal policy rates is taken into account. Based on parameter values that fit U.S. data, the additional welfare costs of raising inflation targets from 2 to 4 percent are estimated at about 0.3 percent of annual real income. A rise to 10 percent would yield additional welfare costs of about 1 percent of real income. Other parameter values yield welfare costs as high as 7 (respectively 30) percent of real income for raising inflation targets from 2 to 4 (respectively from 2 to 10) percent. The full costs of raising inflation targets are likely to be higher because the model used to generate these estimates does not account for higher inflation-induced volatility.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 12/189.

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    Length: 36
    Date of creation: 01 Jul 2012
    Date of revision:
    Handle: RePEc:imf:imfwpa:12/189

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    Related research

    Keywords: Welfare; Interest rates; Monetary policy; Global Financial Crisis 2008-2009; Inflation targeting; Price stabilization; inflation; inflation target; real interest rate; inflation rate; low inflation; percent inflation; real money; nominal interest rate; nominal interest rates; price stability; increase in inflation; high inflation; inflation tax; rise in inflation; rates of inflation; costs of inflation; inflation rates; actual inflation; relative prices; inflation dynamics; monetary economics; real interest rates; rate of inflation; inflation forecasts; rising inflation; percent inflation rate; moderate inflation; higher rates of inflation; real wages; retail price index; relative price; real rate of interest; moderate inflations; high rates of inflation; inflationary expectations; real output; price level; nominal variables; steady-state inflation; annual inflation rate; effects of inflation; monetary base; annual inflation; real value; effect of inflation; inflation data; inflation crises;

    This paper has been announced in the following NEP Reports:

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    1. Bruce E. Hansen, 1997. "Threshold effects in non-dynamic panels: Estimation, testing and inference," Boston College Working Papers in Economics 365, Boston College Department of Economics.
    2. Joseph Gagnon & Matthew Raskin & Julie Remache & Brian Sack, 2010. "Large-scale asset purchases by the Federal Reserve: did they work?," Staff Reports 441, Federal Reserve Bank of New York.
    3. Klaus Adam & Roberto M. Billi, 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Research Working Paper RWP 05-08, Federal Reserve Bank of Kansas City.
    4. Rodriguez-Palenzuela, Diego & Castelnuovo, Efrem & Nicoletti-Altimari, Sergio, 2003. "Definition of price stability, range and point inflation targets: the anchoring of long-term inflation expectations," Working Paper Series 0273, European Central Bank.
    5. Rubens Penha Cysne, 2009. "Bailey's Measure of the Welfare Costs of Inflation as a General-Equilibrium Measure," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(2-3), pages 451-459, 03.
    6. Schmitt-Grohé, Stephanie & Uribe, Martín, 2010. "The Optimal Rate of Inflation," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 13, pages 653-722 Elsevier.
    7. Scott Roger & Mark R. Stone, 2005. "On Target? the International Experience with Achieving Inflation Targets," IMF Working Papers 05/163, International Monetary Fund.
    8. Roberto M. Billi & George A. Kahn, 2008. "What is the optimal inflation rate?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 5-28.
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