The Optimal Inflation Target in an Economy with Limited Enforcement
FRB of St. Louis Working Paper No. 2007-037B
31 Pages Posted: 6 Sep 2007
Date Written: November 1, 2007
We formulate the central bank's problem of selecting an optimal long-run inflation rate as the choice of a distorting tax by a planner who wishes to maximize discounted stationary utility for a heterogeneous population of infinitely-lived households in an economy with constant aggregate income. Households are divided into cash agents, who store value in currency alone, and credit agents who have access to both currency and loans. The planner's problem is equivalent to choosing inflation and nominal rates consistent with a resource constraint, and with an incentive constraint that ensures credit agents prefer the superior consumption-smoothing power of loans to that of currency. We show that the optimum implied rate of inflation is positive, and the optimum implied nominal interest rate is higher than the inflation rate, if the social welfare function weighs credit agents no more than their population fraction.
Keywords: deflation, debt constraints, limited participation, monetary policy, Friedman rule
JEL Classification: E31, E42, E58
Suggested Citation: Suggested Citation