Monetary policy in an economy with both downwardly rigid wages and a transaction motive for money demand is studied using a dynamic stochastic general equilibrium model. The two key features of the model imply that both Tobin's "inflation grease" argument and Friedman's rule are operative, and so optimal inflation may be positive or negative. The Simulated Method of Moments is used to estimate the nonlinear model based on its second-order approximation. Results indicate that the Ramsey policy that maximizes social welfare involves an average inflation rate of about 0.4% per year. In the more realistic case where a central banker follows a simple targeting policy, the optimal inflation target is about 1% per year. We view this result as providing support for the low, but strictly positive, inflation targets used in many countries.
Bibliographical noteFunding Information:
We received helpful comments from Shigenori Shiratsuka; Oleksiy Kryvtsov; and participants in seminars at the Bank of Canada, the National Bank of Belgium, McGill University, the Annual Conference of the Canadian Economics Association (Toronto), and the JEDC conference on Frontiers in Structural Macroeconomic Modeling. The financial support of the Social Sciences and Humanities Research Council is gratefully acknowledged. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System.
- Asymmetric effects of monetary policy
- Downward nominal wage rigidity
- Nonlinear dynamics
- Optimal inflation
ASJC Scopus subject areas
- Economics and Econometrics
- Control and Optimization
- Applied Mathematics