NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Inflation Inertia and Credible Disinflation - The Open Economy Case

Guillermo Calvo, Oya Celasun, Michael Kumhof

NBER Working Paper No. 9557
Issued in March 2003
NBER Program(s):   IFM

This paper develops a model of inflation inertia based on optimizing forward looking staggered price setting in a small open economy. Unlike in current models of sticky prices, transitions to a lower steady state inflation rate take time even if they are fully credible, and they are associated with significant output losses. There is a welfare trade-off between these output losses and the gains from smaller inflationary distortions. For reasonable parameter values inflation stabilization improves welfare. The optimal steady state is reached at the Friedman rule. Technical appendices are available at www.nber.org/data-appendix/w9557/ inert-techapp.pdf

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Published: Calvo, Guillermo, O. Celasun and M. Kumhof. “Inflation Inertia and Credible Disinflation – The Open Economy Case." Journal of International Economics (2007).

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