Optimal Inflation for the U.S.

By Roberto M. Billi
First version: April 2007
This version: March 2009
RWP 07-03
Research Division
Federal Reserve Bank of Kansas City

Abstract    

Previous studies do not provide direct estimates of the optimal (long-run mean) inflation rate that maximizes the public's economic well-being, which is essential information for formulating a long-run inflation target. This paper provides direct estimates of the optimal inflation rate in a small New-Keynesian model subject to an occasionally-binding zero lower bound on nominal interest rates and worst-case scenarios of model uncertainty. The optimal inflation rate is between 0.7 percent per year (no model uncertainty) and 1.4 percent per year (extreme model uncertainty) when measured using the PCE price index. The paper shows that the policymaker can practically implement the optimal inflation rate and completely avoid hitting the zero lower bound when it commits merely to a superinertial Taylor rule with a sufficiently high degree of policy inertia. The optimal inflation rate, however, is more than 14 percent per year when the policymaker makes no commitment about future policies.

Keywords: commitment, discretion, liquidity trap, long-run tradeoffs, long-run stationary distribution, nonlinear monetary policy, stochastic robust control

JEL Classification: C63, E31, E52
 

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