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The Optimal Inflation Target

Paper Session

Saturday, Jan. 5, 2019 10:15 AM - 12:15 PM

Atlanta Marriott Marquis, International C
Hosted By: American Economic Association
  • Chair: Jón Steinsson, University of California-Berkeley

Estimating the Optimal Inflation Target from Micro Price Data

Klaus Adam
,
University of Oxford
Henning Weber
,
Deutsche Bundesbank

Abstract

We present a sticky price model with a product life-cycle that incorporates rich forms of product-level heterogeneity. We derive analytically the optimal steady-state inflation rate, i.e., the optimal inflation target, and show that it generically differs from zero. We show that the optimal inflation target depends on product-level trends present over the product life-cycle and that these trends can be estimated in a parameter-free way from micro price data underlying the construction of the CPI index. Performing such an esimation using U.K. micro data, we find that the optimal U.K. inflation target increased from a range of 1.4%-1.8% in 1996 to 2.6%-3.2% in 2016.

The Optimal Inflation Target and the Natural Rate of Interest

Philippe Andrade
,
Bank of France
Jordi Gali
,
CREI and Pompeu Fabra University
Hervé Le Bihan
,
Bank of France
Julien Matheron
,
Bank of France

Abstract

We study how changes in the value of the steady-state real interest rate affect the optimal inflation target, both in the U.S. and the euro area, using an estimated New Keynesian DSGE model that incorporates the zero (or effective) lower bound on the nominal interest rate. We find that this relation is downward sloping, but its slope is not necessarily one-for-one: increases in the optimal inflation rate are generally lower than declines in the steady-state real interest rate. Our approach allows us not only to assess the uncertainty surrounding the optimal inflation target, but also to determine the latter while taking into account the parameter uncertainty facing the policy maker, including uncertainty with regard to the determinants of the steady-state real interest rate. We find that in the currently empirically relevant region for the US as well as the euro area, the slope of the curve is close to -0.9. That finding is robust to allowing for parameter uncertainty.

A Plucking Model of Business Cycles

Stéphane Dupraz
,
Bank of France
Emi Nakamura
,
University of California-Berkeley
Jón Steinsson
,
University of California-Berkeley

Abstract

The dynamics of unemployment fit what Milton Friedman labeled a plucking model: a rise in unemployment is followed by a fall of similar amplitude, but the amplitude of the rise does not depend on the previous fall. We develop a microfounded plucking model of the business cycle to account for these phenomena. The model features downward nominal wage rigidity within an explicit search model of the labor market. Our search framework implies that downward nominal wage rigidity is fully consistent with optimizing behavior and equilibrium. We reassess the costs of business cycle fluctuations through the lens of the plucking model. Contrary to New-Keynesian models where fluctuations are cycles around an average natural rate, the plucking model generates fluctuations that are gaps below potential (as in Old-Keynesian models). In this model, business cycle fluctuations raise not only the volatility but also the average level of unemployment, and stabilization policy can reduce the average level of unemployment and therefore yield sizable welfare benefits.
Discussant(s)
Yuriy Gorodnichenko
,
University of California-Berkeley
Olivier Coibion
,
University of Texas-Austin
Antonella Trigari
,
Bocconi University
JEL Classifications
  • E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit
  • E3 - Prices, Business Fluctuations, and Cycles