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On Price Stability and Welfare

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  • Etienne B Yehoue

Abstract

The financial crisis in the advanced countries that began in 2007 has led central bankers to adopt unconventional policy measures as policy interest rates neared the zero bound. One suggestion (Blanchard, Dell’Ariccia, and Mauro, 2010) has been to raise inflation targets to provide more room for policy rate easing during crises. This paper addresses a different issue: the relationship between inflation and welfare. The literature is surveyed and a model is developed. A key conclusion is that an increase in inflation targets gives rise to additional welfare costs, even after the extra room to maneuver above the zero lower bound for nominal policy rates is taken into account. Based on parameter values that fit U.S. data, the additional welfare costs of raising inflation targets from 2 to 4 percent are estimated at about 0.3 percent of annual real income. A rise to 10 percent would yield additional welfare costs of about 1 percent of real income. Other parameter values yield welfare costs as high as 7 (respectively 30) percent of real income for raising inflation targets from 2 to 4 (respectively from 2 to 10) percent. The full costs of raising inflation targets are likely to be higher because the model used to generate these estimates does not account for higher inflation-induced volatility.

Suggested Citation

  • Etienne B Yehoue, 2012. "On Price Stability and Welfare," IMF Working Papers 12/189, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:12/189
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    References listed on IDEAS

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    1. Hansen, Bruce E., 1999. "Threshold effects in non-dynamic panels: Estimation, testing, and inference," Journal of Econometrics, Elsevier, vol. 93(2), pages 345-368, December.
    2. Adam, Klaus & Billi, Roberto M., 2007. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 728-752, April.
    3. Scott Roger & Mark R. Stone, 2005. "On Target? the International Experience with Achieving Inflation Targets," IMF Working Papers 05/163, International Monetary Fund.
    4. Joseph E. Gagnon & Matthew Raskin & Julie Remache & Brian P. Sack, 2011. "Large-scale asset purchases by the Federal Reserve: did they work?," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 41-59.
    5. Rubens Penha Cysne, 2009. "Bailey's Measure of the Welfare Costs of Inflation as a General-Equilibrium Measure," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(2-3), pages 451-459, March.
    6. Castelnuovo, Efrem & Nicoletti-Altimari, Sergio & Rodriguez-Palenzuela, Diego, 2003. "Definition of price stability, range and point inflation targets: the anchoring of long-term inflation expectations," Working Paper Series 273, European Central Bank.
    7. Schmitt-Grohé, Stephanie & Uribe, Martín, 2010. "The Optimal Rate of Inflation," Handbook of Monetary Economics,in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 13, pages 653-722 Elsevier.
    8. Roberto M. Billi & George A. Kahn, 2008. "What is the optimal inflation rate?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 5-28.
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    More about this item

    Keywords

    Price stabilization; Global Financial Crisis 2008-2009; Inflation targeting; Monetary policy; Interest rates; Welfare; Inflation; inflation target; real interest rate; inflation rate; low inflation;

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