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Optimal inflation persistence: Ramsey taxation with capital and habits

  • Sanjay Chugh

Ramsey models of fiscal and monetary policy with perfectly-competitive product markets and a fixed supply of capital predict highly volatile inflation with no serial correlation. In this paper, we show that an otherwise-standard Ramsey model that incorporates capital accumulation and habit persistence predicts highly persistent inflation. The result depends on increases in either the ability to smooth consumption or the preference for doing so. The effect operates through the Fisher relationship: a smoother profile of consumption implies a more persistent real interest rate, which in turn implies persistent optimal inflation. Our work complements a recent strand of the Ramsey literature based on models with nominal rigidities. In these models, inflation volatility is lower but continues to exhibit very little persistence. We quantify the effects of habit and capital on inflation persistence and also relate our findings to recent work on optimal fiscal policy with incomplete markets.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 829.

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Date of creation: 2005
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Handle: RePEc:fip:fedgif:829
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  10. Andrew Atkeson & V.V. Chari & Patrick J. Kehoe, 1999. "Taxing capital income: a bad idea," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 3-17.
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  14. Benigno, Pierpaolo & Woodford, Michael, 2004. "Optimal Taxation in an RBC Model: A Linear-Quadratic Approach," CEPR Discussion Papers 4764, C.E.P.R. Discussion Papers.
  15. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Optimal Fiscal and Monetary Policy under Imperfect Competition," Departmental Working Papers 200101, Rutgers University, Department of Economics.
  16. Sydney Ludvigson & Xiaohong Chen, 2004. "Land of Addicts? An Empirical Investigation of Habit-Based Asset Pricing Models," 2004 Meeting Papers 692, Society for Economic Dynamics.
  17. V. V. Chari & Patrick J. Kehoe, 1998. "Optimal fiscal and monetary policy," Staff Report 251, Federal Reserve Bank of Minneapolis.
  18. Calvo, Guillermo A & Guidotti, Pablo E, 1993. "On the Flexibility of Monetary Policy: The Case of the Optimal Inflation Tax," Review of Economic Studies, Wiley Blackwell, vol. 60(3), pages 667-87, July.
  19. Carlstrom, Charles T., 2004. "Comments on "Optimal fiscal and monetary policy under imperfect competition"," Journal of Macroeconomics, Elsevier, vol. 26(2), pages 219-222, June.
  20. George-Marios Angeletos, 2002. "Fiscal Policy With Noncontingent Debt And The Optimal Maturity Structure," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 1105-1131, August.
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