Wednesday, June 23, 2010

Does the "zero bound" imply that inflation targets should be raised? Part II

A new (and recommended) NBER working paper (ungated version can be downloaded from here (it's the first entry under "working papers") by Olivier Coibion, Yuriy Gorodnichenko, and Johannes F. Wieland says no.

"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. In our models, price level targeting delivers large welfare gains and a very low optimal inflation rate consistent with price stability."

So basically, they almost agree with Uribe & Schmitt- Grohe, who argue that the optimal inflation rate is zero or negative.


Norman said...

"price level targeting delivers large welfare gains and a very low optimal inflation rate"

Sounds a lot like Scott Sumner's preferred policy (although he is under the impression that higher inflation targets is an imperfect substitute).

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