Working Paper: CEPR ID: DP7864
Authors: Stephanie Schmitt-Grohé; Martín Uribe
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 Codes: E31; E4; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal monetary policy (E63) | minimize the opportunity cost of holding money (E41) |
| setting the nominal interest rate to zero (E43) | negative optimal rate of inflation (E31) |
| nominal frictions and price stickiness (E31) | optimal monetary policy (E63) |
| foreign demand for domestic currency (F31) | deviations from the Friedman rule (E19) |
| tax incompleteness (H26) | higher optimal inflation rate (E31) |
| sticky prices and money demand (E41) | optimal rate of inflation below observed targets (E52) |
| observed inflation targets (E31) | puzzle for monetary theory (E19) |
| Friedman rule (E19) | negative optimal rate of inflation (E31) |