Optimal Monetary Policy Under Low Trend Inflation

28 Pages Posted: 17 Dec 2007

Date Written: November 2007

Abstract

In the monetary policy literature it is commonly assumed that trend inflation is zero, despite overwhelming evidence that zero inflation is neither empirically relevant nor a practical objective for central bank policy. We therefore extend the standard New Keynesian model to allow for positive trend inflation, showing that even low trend inflation has strong effects on optimal monetary policy and the dynamics of inflation, output, and interest rates. Under discretion, the efficient policy deteriorates and there is no guarantee of determinacy. Even with commitment, targeting non-zero trend inflation leads to substantial welfare losses. Our results serve as a warning against indiscriminate use of models assuming zero trend inflation.

Keywords: Optimal monetary policy, trend inflation

JEL Classification: E31, E52

Suggested Citation

Ropele, Tiziano and Ascari, Guido, Optimal Monetary Policy Under Low Trend Inflation (November 2007). Bank of Italy Temi di Discussione (Working Paper) No. 647, Available at SSRN: https://ssrn.com/abstract=1075185 or http://dx.doi.org/10.2139/ssrn.1075185

Tiziano Ropele (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Guido Ascari

University of Pavia ( email )

27100 Pavia
Italy
+39 0382 506211 (Phone)
+39 304226 (Fax)

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