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: Suggested Citation
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