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Optimal Inflation Rate in a Life-Cycle Economy

Author

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  • Takemasa Oda

    (Director and Senior Economist, Institute for Monetary and Economic Studies, Bank of Japan (E-mail: takemasa.oda@boj.or.jp))

Abstract

This paper investigates long-run effects of inflation and deflation in a monetary life-cycle model that incorporates both capital stock and elastic labor supply as production factors. The model also introduces the zero lower bound on the nominal interest rate. The findings of this paper are twofold. First, in contrast to a result obtained from most neoclassical monetary models with an infinitely lived representative agent, the Friedman rule is not optimal and mild inflation can be desirable in this model. The Tobin effect on capital stock is encouraged by redistribution among households and therefore dominates distortionary effects of the inflation tax on labor supply and consumption. Importantly, the optimal rate of inflation depends on how inflation tax revenues are rebated to households. Second, there is a remarkable asymmetry in terms of welfare costs between inflation and deflation. For a lower rate of inflation than the rate that makes the nominal interest rate just zero, the Tobin effect works strongly in a deflationary direction because households are willing to hold more money, thus depressing aggregate output and social welfare significantly. This result reinforces the validity of pursuing mild inflation to evade the risk of hitting the zero lower bound.

Suggested Citation

  • Takemasa Oda, 2016. "Optimal Inflation Rate in a Life-Cycle Economy," IMES Discussion Paper Series 16-E-05, Institute for Monetary and Economic Studies, Bank of Japan.
  • Handle: RePEc:ime:imedps:16-e-05
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    File URL: http://www.imes.boj.or.jp/research/papers/english/16-E-05.pdf
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    References listed on IDEAS

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    1. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
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    More about this item

    Keywords

    Friedman rule; Zero lower bound; Tobin effect; Inflation tax; Redistribution;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • O42 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - Monetary Growth Models

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