The Optimal Rate Of Inflation∗

Observed inflation targets around the industrial world are concentrated at two percent per year. This chapter investigates the extent to which the observed magnitudes of inflation targets are consistent with the optimal rate of inflation predicted by leading theories of monetary nonneutrality. We find that consistently those theories imply that the optimal rate of inflation ranges from minus the real rate of interest to numbers insignificantly above zero. Furthermore, we argue that the zero bound on nominal interest rates does not represent an impediment for setting inflation targets near or below zero. Finally, we find that central banks should adjust their inflation targets upward by the size of the quality bias in measured inflation only if hedonic prices are more sticky than are non-quality-adjusted prices. This paper was written for the Elsevier/North-Holland Handbook of Monetary Economics, Volume 3, edited by Benjamin M. Friedman and Michael Woodford. We thank Jordi Gaĺı and Pedro Teles for comments. Columbia University, CEPR, and NBER. E-mail: [email protected]. Columbia University and NBER. E-mail: [email protected].