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Optimal Trend Inflation and Monetary Policy under Trending Relative Prices

January 2007
Toyoichiro Shirota*1

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In the standard new Keynesian models, the optimal inflation rate is zero while the long-run inflation rate is non-zero positive in many countries. In this paper, we provide a new rationale for the non-zero trend inflation by utilizing the productivity gap between the intermediate-goods sector and the final-goods sector. The productivity gap among the sectors creates the relative price trend of the CPI and the PPI, which is observed in the actual data. Then, we show that the Ramsey-optimal inflation rate of the CPI is positive while that of the PPI is negative. In addition, the efficient allocation cannot be achieved under the productivity gap. Finally, we investigate the optimal monetary policy response to a shock under the trend inflation. Our results suggest that non-zero trend inflation dramatically alters the optimal monetary policy.

JEL classification: E31; E32; E52

Trend inflation; CPI; PPI; Optimal monetary policy; Relative price trend; Sectoral productivity gap

I am grateful to Hideo Hayakawa, Masahiro Higo, and Takayuki Tsuruga for useful suggestions. I thank Hidetaka Enomoto, Ichiro Fukunaga, Hibiki Ichiue, Takeshi Kimura, Koji Nakamura, Tomohiro Sugo, Kozo Ueda, and seminar participants at the Bank of Japan and the monetary policy workshop for comments. The analysis and conclusions set forth are those of the author and do not indicate concurrence by other members of the research staff or the Bank of Japan.

  • *1 Economic Analysis, Research and Statistics Dept., Bank of Japan;


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