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The optimal inflation rate revisited

  • Giovanni Di Bartolomeo

    ()

    (University of Teramo (Italy))

  • Patrizio Tirelli

    ()

    (University of Milano Bicocca (Italy))

  • Nicola Acocella

    ()

    (Department of Methods and Models for Economics, Territory and Finance MEMOTEF, Sapienza University of Rome (Italy))

We challenge the widely held belief that New Keynesian models cannot predict an optimal positive inflation rate. In fact we find that even for the US economy, characterized by relatively small government size, optimal trend inflation is justified by the Phelps argument that the inflation tax should be part of an optimal (distortionary) taxation scheme. This mainly happens because, unlike standard calibrations of public expenditures that focus on public consumption-to-GDP ratios, we also consider the diverse, highly distortionary effect of public transfers to households. Our prediction of the optimal inflation rate is broadly consistent with recent estimates of the Fed inflation target. We also contradict the view that the Ramsey-optimal policy should minimize inflation volatility over the business cycle and induce near-random walk dynamics of public debt in the long run. In fact optimal fiscal and monetary policies should stabilize long-run debt-to-GDP ratios in order to limit tax (and inflation) distortions in steady state. This latter result is strikingly similar to policy analyses in the aftermath of the 2008 financial crisis.

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File URL: http://www.memotef.uniroma1.it/sites/dipartimento/files/wpapers/documenti/FullTextWP76.pdf
File Function: October 2010
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Paper provided by Sapienza University of Rome, Metodi e modelli per l'economia, il territorio e la finanza MEMOTEF in its series Working Papers with number 76/10.

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Handle: RePEc:rsq:wpaper:2/10
Contact details of provider: Web page: http://www.memotef.uniroma1.it/RePEc/index.html

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  1. Philip Du Caju & Erwan Gautier & Daphne Momferatu & Melanie Ward-Warmedinger, 2009. "Institutional Features of Wage Bargaining in 23 European Countries, the US and Japan," Ekonomia, Cyprus Economic Society and University of Cyprus, vol. 12(2), pages 57-108, Winter.
  2. Jesús Fernández-Villaverde & Juan F Rubio-Ramírez, 2007. "How Structural Are Structural Parameters?," Levine's Bibliography 843644000000000057, UCLA Department of Economics.
  3. Jordi Galí & Pau Rabanal, 2005. "Technology Shocks and Aggregate Fluctuations: How Well Does the Real Business Cycle Model Fit Postwar U.S. Data?," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 225-318 National Bureau of Economic Research, Inc.
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