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The Optimal Inflation Rate in New Keynesian Models

Author

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  • Olivier Coibion

    (Department of Economics, College of William and Mary)

  • Yuriy Gorodnichenko

    (Department of Economics, University of California, Berkeley)

  • Johannes Wieland

    (Department of Economics, niversity of California, Berkeley)

Abstract

We study the effects of positive steady-state inflation in New Keynesian models subject to the zero bound on interest rates. We derive the utility-based welfare loss function taking into account the effects of positive steady-state inflation and show that steady-state inflation affects welfare through three distinct channels: steady-state effects, the magnitude of the coefficients in the utility-function approximation, and the dynamics of the model. We solve for the optimal level of inflation in the model and find that, for plausible calibrations, the optimal inflation rate is low, less than two percent, even after considering a variety of extensions, including price indexation, endogenous price stickiness, capital formation, model uncertainty, and downward nominal wage rigidities. On the normative side, price level targeting delivers large welfare gains and a very low optimal inflation rate consistent with price stability.

Suggested Citation

  • Olivier Coibion & Yuriy Gorodnichenko & Johannes Wieland, 2010. "The Optimal Inflation Rate in New Keynesian Models," Working Papers 91, Department of Economics, College of William and Mary.
  • Handle: RePEc:cwm:wpaper:91
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    More about this item

    Keywords

    Optimal inflation; New Keynesian; zero bound; price level targeting;
    All these keywords.

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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