Nominal Rigidities and the Optimal Rate of Inflation

Abstract

This paper analyses two reasons why inflation may interfere with price adjustment so as to create inefficiencies in resource allocation at low rates of inflation. The first argument is that the higher the rate of inflation the lower the likelihood that downward nominal rigidities are binding (the Tobin argument) which implies a non-linear Phillips-curve. The second argument is that low inflation strengthens nominal price rigidities and thus impairs the flexibility of the price system resulting in a less efficient resource allocation. It is argued that inflation can be too low from a welfare point of view due to the presence of nominal rigidities, but the quantitative importance is an open question. Keywords:Nominal rigidities, allocative efficiency, optimal rate of inflation JEL classification: E20, E30 * Paper prepared for the conference "Implementation of Price Stability", Frankfurt, September 1998.Comments and suggestions from conference participants and in particular the discussants Roel Beetsma and Axel Weber are gratefully acknowledged.** Department of Economics, University of Aarhus, DK-8000 Aarhus C, Denmark, E-mail: tandersen@econ.au.dk 2 1 Feldstein (1996) argues that these effects are dominated by inflationary distortions in the taxation system, in particular between inflation and capital income taxation.

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