Working Paper

The Optimal Inflation Rate with Discount Factor Heterogeneity

Abstract: This paper shows that deviations from long-run price stability are optimal in the presence of price stickiness whenever profit and utility flows are discounted at a different rate. In that case, a monetary authority acting under commitment will choose a path for the inflation rate that ends with a non-zero value. Such a property is relevant in a wide range of macroeconomic environments. I first illustrate this by studying optimal monetary policy in a New Keynesian model with a perpetual youth structure. In this setting, profit flows are discounted more heavily than utility flows and the optimal inflation target is equal to 3.2 percent in a baseline calibration of the model. I also show that this property leads to a positive long-run inflation rate in models with firm entry and exit and in environments with search and matching frictions in the labor market and another form of nominal rigidity, wage stickiness.

Keywords: Discount factor heterogeneity; Inflation target; optimal inflation rates; Optimal monetary policy; Perpetual youth; Sticky prices;

JEL Classification: E31; E32; E52;

https://doi.org/10.17016/FEDS.2018.086

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2018-12

Number: 2018-086

Pages: 57 pages