The Optimal Rate of Inflation
Columbia University - Graduate School of Arts and Sciences - Department of Economics; Centre for Economic Policy Research (CEPR)
Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)
CEPR Discussion Paper No. DP7864
Observed inflation targets around the industrial world are concentrated at two percent per year. This paper investigates the extent to which the observed magnitudes of inflation targets are consistent with the optimal rate of inflation predicted by leading theories of monetary non-neutrality. We find that consistently those theories imply that the optimal rate of inflation ranges from minus the real rate of interest to numbers insignificantly above zero. Furthermore, we argue that the zero bound on nominal interest rates does not represent an impediment for setting inflation targets near or below zero. Finally, we find that central banks should adjust their inflation targets upward by the size of the quality bias in measured inflation only if hedonic prices are more sticky than are non-quality-adjusted prices.
Number of Pages in PDF File: 80
Keywords: downward nominal rigidities, foreign demand for money, Friedman Rule, quality bias, Ramsey policy, sticky-prices, zero bound
JEL Classification: E31, E4, E5working papers series
Date posted: July 19, 2010
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