Working Paper

Output-Inflation Trade-offs and the Optimal Inflation Rate


Abstract: In staggered price models, a non-CES aggregator of differentiated goods generates empirically plausible short- and long-run trade-offs between output and inflation: lower trend inflation flattens the Phillips curve and decreases steady-state output by increasing markups. We show that the aggregator reduces both the steady-state welfare cost of higher trend inflation and the inflation-related weight in a model-based welfare function for higher trend inflation. Consequently, optimal trend inflation is moderately positive even without considering the zero lower bound on nominal interest rates. Moreover, the welfare difference between 2 percent and 4 percent inflation targets is much smaller than in the CES aggregator case.

Keywords: non-CES aggregator; output-inflation trade-off; optimal trend inflation;

JEL Classification: E52; E58;

https://doi.org/10.26509/frbc-wp-202020

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Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers

Publication Date: 2020-07-02

Number: 202020