On the Welfare and Cyclical Implications of Moderate Trend Inflation

Abstract

We acknowledge Yuriy Gorodnichenko and Juan Rubio-Ramirez for helpful comments and suggestions at an early stage of this project, Sylvain Leduc for useful comments on the current draft and Jean-Gardy Victor for capable research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.© 2015 by Guido Ascari, Louis Phaneuf, and Eric Sims. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. ABSTRACTWe offer a comprehensive evaluation of the welfare and cyclical implications of moderate trend inflation. In an extended version of a medium-scale New Keynesian model, recent proposals to increase trend inflation from 2 to 4 percent would generate a consumption-equivalent welfare loss of 3.7 percent based on the non-stochastic steady state and of 6.9 percent based on the stochastic mean. Welfare costs of this magnitude are driven by four main factors: i) multiperiod nominal wage contracting, ii) trend growth in investment-specific and neutral technology, iii) roundaboutness in the U.S. production structure, and iv) and the interaction between trend inflation and shocks to the marginal efficiency of investment (MEI), insofar that this type of shock is sufficiently persistent. Moreover, moderate trend inflation has important cyclical implications. It interacts much more strongly with MEI shocks than with either productivity or monetary shocks.

Long‐Run Inflation and the Distorting Effects of Sticky Wages and Technical Change

“…Assessing inflation costs in the 0–2% and 2–4% inflation bands allows us to show that raising trend inflation by 2% is more costly from 2% to 4% than from 0% to 2%. Therefore, as Ascari, Phaneuf, and Sims () emphasize, the FED should be cautious when it considers increasing the inflation target by some moderate amount from 2% to 3% or 4%. With the 0–7% inflation band, we can assess how a high level of inflation affects wage dispersion relative to price dispersion.…”

“…Following Ascari, Phaneuf, and Sims (), our model also accounts for positive trend inflation and real per capita output growth. Despite some similarities, there are three main differences between our approach and theirs.…”

Welfare Costs of Shifting Trend Inflation: Staggered Wage and Price Contracts

“…The inefficient utilization of labour then is magnified by constant positive trend inflation Ascari et al . ().…”

“…This conclusion is aligned with findings in Ascari et al . () who also measure welfare costs of trend inflation in the model with both staggered price and wage contracts. Our study provides other evidence that the costs of shifting trend inflation are signified when considering the staggered wage contracts.…”

“…Ascari et al . () study a medium‐scale model with staggered prices and staggered wages to show significant welfare costs of constant trend inflation. They also emphasize the role of staggered wage contracts on these costs.…”