The Optimal Inflation Rate Revisited
The authors challenge the widely held belief that New Keynesian models cannot predict an optimal positive inflation rate. In fact they find that even for the US economy, characterized by relatively small government size, optimal trend inflation is justified by the Phelps argument that the inflation tax should be part of an optimal (distortionary) taxation scheme. This mainly happens because, unlike standard calibrations of public expenditures that focus on public consumption-to-GDP ratios, they also consider the diverse, highly distortionary effect of public transfers to households. The prediction of the optimal inflation rate is broadly consistent with recent estimates of the Fed inflation target.