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Inflation Stabilization and Welfare

  • Michael Woodford

This paper derives loss functions for monetary policy that are grounded in the welfare of private agents, for optimizing models with nominal price rigidities. Inflation stabilization enhances welfare, insofar as variable inflation results in real distortions when prices are not adjusted throughout the economy in a perfectly synchronized fashion. The exact sense in which inflation variability matters for welfare, however, depends upon the details of price-setting behavior. Conditions are described under which optimal policy involves complete stabilization of the price level. This may be optimal even in the presence of 'supply shocks' of several possible sorts, and even in the presence of distortions that imply that the optimal output gap is positive (despite existence of a long-run Phillips curve). At the same time discussed why complete price-level stabilization is not optimal in more complicated (and probably more realistic) settings.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8071.

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Date of creation: Jan 2001
Date of revision:
Publication status: published as Contributions to Macroeconomics (B.E. Journal of Macroeconomics), Vol. 2: Iss. 1, Article 1, (2002) p. 1009
Handle: RePEc:nbr:nberwo:8071
Note: EFG ME
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