33 Pages Posted: 13 Aug 2008
Date Written: May 11, 2008
This paper brings the elements of growth to the standard New Keynesian model to analyze the optimal rate of inflation. To our knowledge, this is the first theoretical attempt to consider the effects of growth in the determination of optimal monetary policies. With both elements of price and wage rigidities, inflation creates distortions due to wage and price dispersions and due to its effects on monopolistic mark-ups by price and wage setters. The choice of the optimal inflation rate balances these distortions at the margin. The paper first characterizes these tradeoffs in the steady-state version of the model and finds that, for a wide range of parameter values, the optimal rate of inflation is negative. When the monetary policy is committed to adjust nominal interest rates to ensure its objective of price stability, it might target a deflation rate. This is due to the fact that the mean of inflation is affected by shocks, and on average, this mean is approaching zero. The welfare analysis then reveals that real growth decreases the welfare cost of inflation.
Keywords: Price Inflation, Wage Inflation, Growth, Staggered Contracts
JEL Classification: E31, E52
Suggested Citation: Suggested Citation
Entekhabi, Niloufar, Technical Change, Wage and Price Dispersion, and the Optimal Rate of Inflation (May 11, 2008). Available at SSRN: https://ssrn.com/abstract=1218078 or http://dx.doi.org/10.2139/ssrn.1218078