DP7864 The Optimal Rate of Inflation

Author(s): Stephanie Schmitt-Grohé, Martín Uribe
Publication Date: June 2010
Keyword(s): downward nominal rigidities, foreign demand for money, Friedman Rule, quality bias, Ramsey policy, sticky-prices, zero bound
JEL(s): E31, E4, E5
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7864

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.