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Optimal monetary policy under low trend inflation

  • Guido Ascari


    (University of Pavia)

  • Tiziano Ropele


    (Bank of Italy)

In the monetary policy literature it is commonly assumed that trend inflation is zero, despite overwhelming evidence that zero inflation is neither empirically relevant nor a practical objective for central bank policy. We therefore extend the standard New Keynesian model to allow for positive trend inflation, showing that even low trend inflation has strong effects on optimal monetary policy and the dynamics of inflation, output, and interest rates. Under discretion, the efficient policy deteriorates and there is no guarantee of determinacy. Even with commitment, targeting non-zero trend inflation leads to substantial welfare losses. Our results serve as a warning against indiscriminate use of models assuming zero trend inflation.

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Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 647.

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Date of creation: Nov 2007
Date of revision:
Handle: RePEc:bdi:wptemi:td_647_07
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  1. Michael Woodford, 1999. "Optimal Monetary Policy Inertia," NBER Working Papers 7261, National Bureau of Economic Research, Inc.
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  7. Robert Amano & Steve Ambler & Nooman Rebei, 2007. "The Macroeconomic Effects of Nonzero Trend Inflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(7), pages 1821-1838, October.
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  11. Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," CEPR Discussion Papers 4334, C.E.P.R. Discussion Papers.
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