On the Optimal Inflation Rate
In our incomplete markets economy financial frictions affect the optimal inflation target. Households choose portfolios consisting of risky (uninsurable) capital and money. Money is a bubbly store of value. The market outcome is constrained Pareto inefficient due to a pecuniary externality. Each individual agent takes the real interest rate as given, while in the aggregate it is driven by the economic growth rate, which in turn depends on individual portfolio decisions. Higher inflation due to higher money growth lowers the real interest rate (on money) and tilts the portfolio choice towards physical capital investment. The optimal inflation target boosts growth and welfare and is higher for emerging market economies.
We thank Itamar Drechsler for helpful comments and Yann Koby, Christian Wolf and especially Sebastian Merkel for excellent 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.
Markus K. Brunnermeier
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Markus K. Brunnermeier & Yuliy Sannikov, 2016. "On the Optimal Inflation Rate," American Economic Review, vol 106(5), pages 484-489. citation courtesy of