The Optimal Rate of Inflation

80 Pages Posted: 19 Jul 2010

See all articles by Stephanie Schmitt-Grohé

Stephanie Schmitt-Grohé

Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Martín Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: June 2010

Abstract

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.

Keywords: downward nominal rigidities, foreign demand for money, Friedman Rule, quality bias, Ramsey policy, sticky-prices, zero bound

JEL Classification: E31, E4, E5

Suggested Citation

Schmitt-Grohe, Stephanie and Uribe, Martin, The Optimal Rate of Inflation (June 2010). CEPR Discussion Paper No. DP7864, Available at SSRN: https://ssrn.com/abstract=1640386

Stephanie Schmitt-Grohe (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

National Bureau of Economic Research (NBER)

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Martin Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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United States

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