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Optimal long-run inflation and the New Keynesian model

  • Pontiggia, D.

Central banks typically have a long-run inflation target that is modestly positive. However, the standard New Keynesian framework prescribes that zero inflation is the optimal long-run target. In this paper, we show that when the baseline New Keynesian model is extended to allow for rule-of-thumb behavior by price setters, the optimality of zero long-run inflation ceases, and the monetary authority commits to a positive inflation target. The optimality of positive long-run inflation turns on the fact that the aggregate-supply relation does not imply an equivalence, up to first-order and regardless of policy, between the welfare-relevant measure of inflation and the discounted sequence of future output gaps.

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Article provided by Elsevier in its journal Journal of Macroeconomics.

Volume (Year): 34 (2012)
Issue (Month): 4 ()
Pages: 1077-1094

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Handle: RePEc:eee:jmacro:v:34:y:2012:i:4:p:1077-1094
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622617

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