Working Paper: NBER ID: w22133
Authors: Markus K. Brunnermeier; Yuliy Sannikov
Abstract: In our incomplete markets economy financial frictions affect the optimal inflation target. Households choose portfolios consisting of risky (uninsurable) capital and money. Money is a bubbly store of value. The market outcome is constrained Pareto inefficient due to a pecuniary externality. Each individual agent takes the real interest rate as given, while in the aggregate it is driven by the economic growth rate, which in turn depends on individual portfolio decisions. Higher inflation due to higher money growth lowers the real interest rate (on money) and tilts the portfolio choice towards physical capital investment. The optimal inflation target boosts growth and welfare and is higher for emerging market economies.
Keywords: optimal inflation; financial frictions; emerging markets
JEL Codes: E44; E51; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial frictions (G19) | optimal inflation target (E31) |
| Higher inflation due to increased money growth (O42) | lowers real interest rate on money (E43) |
| lowers real interest rate on money (E43) | influences portfolio choices towards physical capital investment (G11) |
| Higher inflation (E31) | boosts growth and welfare (O49) |
| optimal inflation target (E31) | boosts growth and welfare (O49) |
| Higher idiosyncratic risk (D81) | higher optimal inflation rate (E31) |