Working Paper: CEPR ID: DP5424
Authors: Stephanie Schmitt-Grohé; Martín Uribe
Abstract: This paper characterizes Ramsey-optimal monetary policy in a medium-scale macroeconomic model that has been estimated to fit well postwar US business cycles. We find that mild deflation is Ramsey optimal in the long run. However, the optimal inflation rate appears to be highly sensitive to the assumed degree of price stickiness. Within the window of available estimates of price stickiness (between 2 and 5 quarters) the optimal rate of inflation ranges from -4.2 percent per year (close to the Friedman rule) to -0.4 percent per year (close to price stability). This sensitivity disappears when one assumes that lump-sum taxes are unavailable and fiscal instruments take the form of distortionary income taxes. In this case, mild deflation emerges as a robust Ramsey prediction. In light of the finding that the Ramsey optimal inflation rate is negative, it is puzzling that most inflation-targeting countries pursue positive inflation goals. We show that the zero bound on the nominal interest rate, which is often cited as a rationale for setting positive inflation targets, is of no quantitative relevance in the present model. Finally, the paper characterizes operational interest-rate feedback rules that best implement Ramsey-optimal stabilization policy. We find that the optimal interest-rate rule is active in price and wage inflation, mute in output growth, and moderately inertial.
Keywords: interest rate rules; nominal rigidities; ramsey policy; real rigidities
JEL Codes: E52; E61; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| price stickiness (L11) | optimal inflation rate (E31) |
| fiscal policy conditions (E62) | optimal inflation rate (E31) |
| degree of price stickiness (D41) | optimal inflation rate (E31) |
| absence of fiscal tools (E62) | optimal inflation rate (E31) |
| zero lower bound on nominal interest rates (E43) | causal relationships (C32) |
| monetary policy (E52) | inflation stabilization (E31) |