Working Paper: NBER ID: w16093
Authors: Olivier Coibion; Yuriy Gorodnichenko; Johannes F. Wieland
Abstract: We study the effects of positive steady-state inflation in New Keynesian models subject to the zero bound on interest rates. We derive the utility-based welfare loss function taking into account the effects of positive steady-state inflation and show that steady-state inflation affects welfare through three distinct channels: steady-state effects, the magnitude of the coefficients in the utility-function approximation, and the dynamics of the model. We solve for the optimal level of inflation in the model and find that, for plausible calibrations, the optimal inflation rate is low, less than two percent, even after considering a variety of extensions, including price indexation, endogenous price stickiness, capital formation, model-uncertainty, and downward nominal wage rigidities. On the normative side, price level targeting delivers large welfare gains and a very low optimal inflation rate consistent with price stability.
Keywords: Inflation; New Keynesian Models; Welfare Analysis; Zero Lower Bound
JEL Codes: E3; E4; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| positive steady-state inflation (E31) | welfare (I38) |
| higher inflation (E31) | price dispersion (L11) |
| price dispersion (L11) | inefficient resource allocation among firms (D61) |
| inefficient resource allocation among firms (D61) | lower aggregate welfare (D69) |
| higher inflation volatility (E31) | lower aggregate welfare (D69) |
| greater steady-state inflation (E31) | more forward-looking behavior among sticky-price firms (D21) |
| more forward-looking behavior among sticky-price firms (D21) | greater inflation volatility (E31) |
| optimal inflation rate (E31) | welfare outcomes (I38) |