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The Optimal Rate of Inflation

  • Schmitt-Grohé, Stephanie
  • Uribe, Martín

Observed inflation targets around the industrial world are concentrated at two percent per year. This paper investigates the extent to which the observed magnitudes of inflation targets are consistent with the optimal rate of inflation predicted by leading theories of monetary non-neutrality. We find that consistently those theories imply that the optimal rate of inflation ranges from minus the real rate of interest to numbers insignificantly above zero. Furthermore, we argue that the zero bound on nominal interest rates does not represent an impediment for setting inflation targets near or below zero. Finally, we find that central banks should adjust their inflation targets upward by the size of the quality bias in measured inflation only if hedonic prices are more sticky than are non-quality-adjusted prices.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7864.

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Date of creation: Jun 2010
Date of revision:
Handle: RePEc:cpr:ceprdp:7864
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References listed on IDEAS
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  1. Adam, Klaus & Billi, Roberto M, 2003. "Optimal Monetary Policy Under Commitment with a Zero Bound on Nominal Interest Rates," CEPR Discussion Papers 4111, C.E.P.R. Discussion Papers.
  2. Tack Yun, 2005. "Optimal Monetary Policy with Relative Price Distortions," American Economic Review, American Economic Association, vol. 95(1), pages 89-109, March.
  3. Noah Williams & Andrew Levin & Alexei Onatski, 2005. "Monetary Policy under Uncertainty in Micro-Founded Macroeconometric Models," Computing in Economics and Finance 2005 478, Society for Computational Economics.
  4. Stephanie Schmitt-Grohé & Martín Uribe, 2009. "Foreign Demand for Domestic Currency and the Optimal Rate of Inflation," NBER Working Papers 15494, National Bureau of Economic Research, Inc.
  5. Nicolini, Juan Pablo, 1998. "Tax evasion and the optimal inflation tax," Journal of Development Economics, Elsevier, vol. 55(1), pages 215-232, February.
  6. Pierpaolo Benigno & Michael Woodford, 2005. "Inflation Stabilization And Welfare: The Case Of A Distorted Steady State," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1185-1236, December.
  7. David L. Reifschneider & John C. Williams, 1999. "Three lessons for monetary policy in a low inflation era," Finance and Economics Discussion Series 1999-44, Board of Governors of the Federal Reserve System (U.S.).
  8. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, June.
  9. repec:oup:qjecon:v:123:y:2008:i:3:p:863-904 is not listed on IDEAS
  10. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.
  11. repec:oup:qjecon:v:123:y:2008:i:4:p:1415-1464 is not listed on IDEAS
  12. Stephanie Schmitt-Grohe & Martin Uribe, 2009. "On Quality Bias and Inflation Targets," NBER Working Papers 15505, National Bureau of Economic Research, Inc.
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