Regional President Speech

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS THE OPTIMAL INFLATION TARGET IN AN ECONOMY WITH LIMITED ENFORCEMENT GaetanoAntinolfi WashingtonUniversity CostasAzariadis WashingtonUniversityandFRB-St. Louis JamesBullard* FederalReserveBankofSt. Louis NewPerspectivesonMonetaryPolicyDesign Barcelona,Spain 10October2008 ViewsexpressedarethoseoftheauthoranddonotnecessarilyreflectofficialpositionsoftheFOMCortheFederalReserveSystem.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS COMFORT ZONES TypicalFOMCmemberstatements: 1to2percentinflation wouldbeideal. “Smallpositiveinflationisthebestinflationtarget.” Associatedwithshort-termnominalinterestratesnear5percent. Economictheory: nominalinterestratesshouldbezero. Whythedifference?

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS THEORY AND REALITY: WHY THE DIFFERENCE? Japan. Summers(1991): Zeroboundonnominalinterestratesinterferes withstabilizationpolicy. AdamandBilli(2006). Smith(2002). Deflationcausesdisintermediation,harmingthe operationofcreditmarkets. Westudyaversionofthelatter: Asmallamountofinflation“deepensfinancialmarkets”inaway wemakeprecise.

Acontinuumofinfinitely-livedhouseholds. Endowmentsfluctuate. Twoassets: currencyandconsumptionloans. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS WHAT WE DO Endowmenteconomywithconstantaggregateincome.

Endowmentsfluctuate. Twoassets: currencyandconsumptionloans. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS WHAT WE DO Endowmenteconomywithconstantaggregateincome. Acontinuumofinfinitely-livedhouseholds.

Twoassets: currencyandconsumptionloans. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS WHAT WE DO Endowmenteconomywithconstantaggregateincome. Acontinuumofinfinitely-livedhouseholds. Endowmentsfluctuate.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS WHAT WE DO Endowmenteconomywithconstantaggregateincome. Acontinuumofinfinitely-livedhouseholds. Endowmentsfluctuate. Twoassets: currencyandconsumptionloans.

“Townsend-Bewley-type”orcashagentscanonlyusecurrencyin nonnegativeamountstosmoothconsumption. “Kehoe-Levine-type”orcreditagentscanparticipateineither assetmarketsubjecttoendogenousdebtconstraints. Defaultispunishedbyperpetualexclusionfromtheloanmarket butstillpermitsdefaultinghouseholdstoholdnonnegative currency. Inflationwillmakedefaultlessattractive,loosening participationconstraintsandstrengtheningthecreditmarket. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS AGENT TYPES Householdsaredividedintotwotypes.

“Kehoe-Levine-type”orcreditagentscanparticipateineither assetmarketsubjecttoendogenousdebtconstraints. Defaultispunishedbyperpetualexclusionfromtheloanmarket butstillpermitsdefaultinghouseholdstoholdnonnegative currency. Inflationwillmakedefaultlessattractive,loosening participationconstraintsandstrengtheningthecreditmarket. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS AGENT TYPES Householdsaredividedintotwotypes. “Townsend-Bewley-type”orcashagentscanonlyusecurrencyin nonnegativeamountstosmoothconsumption.

Defaultispunishedbyperpetualexclusionfromtheloanmarket butstillpermitsdefaultinghouseholdstoholdnonnegative currency. Inflationwillmakedefaultlessattractive,loosening participationconstraintsandstrengtheningthecreditmarket. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS AGENT TYPES Householdsaredividedintotwotypes. “Townsend-Bewley-type”orcashagentscanonlyusecurrencyin nonnegativeamountstosmoothconsumption. “Kehoe-Levine-type”orcreditagentscanparticipateineither assetmarketsubjecttoendogenousdebtconstraints.

Inflationwillmakedefaultlessattractive,loosening participationconstraintsandstrengtheningthecreditmarket. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS AGENT TYPES Householdsaredividedintotwotypes. “Townsend-Bewley-type”orcashagentscanonlyusecurrencyin nonnegativeamountstosmoothconsumption. “Kehoe-Levine-type”orcreditagentscanparticipateineither assetmarketsubjecttoendogenousdebtconstraints. Defaultispunishedbyperpetualexclusionfromtheloanmarket butstillpermitsdefaultinghouseholdstoholdnonnegative currency.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS AGENT TYPES Householdsaredividedintotwotypes. “Townsend-Bewley-type”orcashagentscanonlyusecurrencyin nonnegativeamountstosmoothconsumption. “Kehoe-Levine-type”orcreditagentscanparticipateineither assetmarketsubjecttoendogenousdebtconstraints. Defaultispunishedbyperpetualexclusionfromtheloanmarket butstillpermitsdefaultinghouseholdstoholdnonnegative currency. Inflationwillmakedefaultlessattractive,loosening participationconstraintsandstrengtheningthecreditmarket.

Deflationisinfeasibleiftheplannerassignspositiveweightto credithouseholds. Inflationhigherthanthelevelrequiredtoslackendebt constraintswillnotbechoseniftheplannerassignssufficient weighttocashhouseholds. Iftheplannerputsarelativeweightgreaterthanzerobutless thanthepopulationweightoncredithouseholds,theoptimum inflationrateispositive. Conclude: Independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS PREVIEW OF MAIN FINDINGS Westudyaparticularsocialplanningproblem,madeprecise below.

Inflationhigherthanthelevelrequiredtoslackendebt constraintswillnotbechoseniftheplannerassignssufficient weighttocashhouseholds. Iftheplannerputsarelativeweightgreaterthanzerobutless thanthepopulationweightoncredithouseholds,theoptimum inflationrateispositive. Conclude: Independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS PREVIEW OF MAIN FINDINGS Westudyaparticularsocialplanningproblem,madeprecise below. Deflationisinfeasibleiftheplannerassignspositiveweightto credithouseholds.

Iftheplannerputsarelativeweightgreaterthanzerobutless thanthepopulationweightoncredithouseholds,theoptimum inflationrateispositive. Conclude: Independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS PREVIEW OF MAIN FINDINGS Westudyaparticularsocialplanningproblem,madeprecise below. Deflationisinfeasibleiftheplannerassignspositiveweightto credithouseholds. Inflationhigherthanthelevelrequiredtoslackendebt constraintswillnotbechoseniftheplannerassignssufficient weighttocashhouseholds.

Conclude: Independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS PREVIEW OF MAIN FINDINGS Westudyaparticularsocialplanningproblem,madeprecise below. Deflationisinfeasibleiftheplannerassignspositiveweightto credithouseholds. Inflationhigherthanthelevelrequiredtoslackendebt constraintswillnotbechoseniftheplannerassignssufficient weighttocashhouseholds. Iftheplannerputsarelativeweightgreaterthanzerobutless thanthepopulationweightoncredithouseholds,theoptimum inflationrateispositive.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS PREVIEW OF MAIN FINDINGS Westudyaparticularsocialplanningproblem,madeprecise below. Deflationisinfeasibleiftheplannerassignspositiveweightto credithouseholds. Inflationhigherthanthelevelrequiredtoslackendebt constraintswillnotbechoseniftheplannerassignssufficient weighttocashhouseholds. Iftheplannerputsarelativeweightgreaterthanzerobutless thanthepopulationweightoncredithouseholds,theoptimum inflationrateispositive. Conclude: Independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS RECENT RELATED LITERATURE AiyagariandWilliamson(2000JET). Relatedenvironment,randomendowments,outsideoptionis Bewley,emphasisonfinancialintermediation,positiveinflation detersdefault,computational. Berentsen,CameraandWaller(2007JET). Relatedenvironment,Lagos-Wright,emphasisonfinancial intermediation,positiveinflationdetersdefault. Ragot(2007). OLGframework. Andolfatto(2007). Antinolfi,Azariadis,andBullard(2007). Moneyistheonlyasset,emphasisondynamicsandequilibrium selection. Sanchez,Williamson,andWright(2007). Blackboardversion.

λ“Kehoe-Levine”orcredittypeagents. 1 λ“Townsend-Bewley”orcashtypeagents. (cid:0) Alltypeshaveidenticalpreferences ∞ ∑ βtu ci (1) t t=0 (cid:16) (cid:17) withdiscountfactor0< β <1,u(c)standard,andi=0,1,2,3. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS ENVIRONMENT Continuumofinfinitely-livedhouseholds.

1 λ“Townsend-Bewley”orcashtypeagents. (cid:0) Alltypeshaveidenticalpreferences ∞ ∑ βtu ci (1) t t=0 (cid:16) (cid:17) withdiscountfactor0< β <1,u(c)standard,andi=0,1,2,3. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS ENVIRONMENT Continuumofinfinitely-livedhouseholds. λ“Kehoe-Levine”orcredittypeagents.

Alltypeshaveidenticalpreferences ∞ ∑ βtu ci (1) t t=0 (cid:16) (cid:17) withdiscountfactor0< β <1,u(c)standard,andi=0,1,2,3. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS ENVIRONMENT Continuumofinfinitely-livedhouseholds. λ“Kehoe-Levine”orcredittypeagents. 1 λ“Townsend-Bewley”orcashtypeagents. (cid:0)

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS ENVIRONMENT Continuumofinfinitely-livedhouseholds. λ“Kehoe-Levine”orcredittypeagents. 1 λ“Townsend-Bewley”orcashtypeagents. (cid:0) Alltypeshaveidenticalpreferences ∞ ∑ βtu ci (1) t t=0 (cid:16) (cid:17) withdiscountfactor0< β <1,u(c)standard,andi=0,1,2,3.

Cashhouseholdsaredividedintotwosub-types,2and3,with mass1 λ/2each. (cid:0) Endowments,interpretedasincomeshares,areperiodic: (1+α,1 α) ift=0,2,... ω0,ω1 = ω2,ω3 = (cid:0) (2) t t t t (1 α,1+α) ift=1,3,... (cid:16) (cid:17) (cid:16) (cid:17) (cid:26) (cid:0) α (0,1)indexesthedegreeofincomevolatility. 2 Aggregateincomeisconstant. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS ENDOWMENTS Credithouseholdsaredividedintotwosub-types,0and1,with massλ/2each.

Endowments,interpretedasincomeshares,areperiodic: (1+α,1 α) ift=0,2,... ω0,ω1 = ω2,ω3 = (cid:0) (2) t t t t (1 α,1+α) ift=1,3,... (cid:16) (cid:17) (cid:16) (cid:17) (cid:26) (cid:0) α (0,1)indexesthedegreeofincomevolatility. 2 Aggregateincomeisconstant. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS ENDOWMENTS Credithouseholdsaredividedintotwosub-types,0and1,with massλ/2each. Cashhouseholdsaredividedintotwosub-types,2and3,with mass1 λ/2each. (cid:0)

α (0,1)indexesthedegreeofincomevolatility. 2 Aggregateincomeisconstant. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS ENDOWMENTS Credithouseholdsaredividedintotwosub-types,0and1,with massλ/2each. Cashhouseholdsaredividedintotwosub-types,2and3,with mass1 λ/2each. (cid:0) Endowments,interpretedasincomeshares,areperiodic: (1+α,1 α) ift=0,2,... ω0,ω1 = ω2,ω3 = (cid:0) (2) t t t t (1 α,1+α) ift=1,3,... (cid:16) (cid:17) (cid:16) (cid:17) (cid:26) (cid:0)

Aggregateincomeisconstant. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS ENDOWMENTS Credithouseholdsaredividedintotwosub-types,0and1,with massλ/2each. Cashhouseholdsaredividedintotwosub-types,2and3,with mass1 λ/2each. (cid:0) Endowments,interpretedasincomeshares,areperiodic: (1+α,1 α) ift=0,2,... ω0,ω1 = ω2,ω3 = (cid:0) (2) t t t t (1 α,1+α) ift=1,3,... (cid:16) (cid:17) (cid:16) (cid:17) (cid:26) (cid:0) α (0,1)indexesthedegreeofincomevolatility. 2

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS ENDOWMENTS Credithouseholdsaredividedintotwosub-types,0and1,with massλ/2each. Cashhouseholdsaredividedintotwosub-types,2and3,with mass1 λ/2each. (cid:0) Endowments,interpretedasincomeshares,areperiodic: (1+α,1 α) ift=0,2,... ω0,ω1 = ω2,ω3 = (cid:0) (2) t t t t (1 α,1+α) ift=1,3,... (cid:16) (cid:17) (cid:16) (cid:17) (cid:26) (cid:0) α (0,1)indexesthedegreeofincomevolatility. 2 Aggregateincomeisconstant.

The“unbanked.” Noclaimscanbeenforcedonthemorbythem. Creditagentsmayenterintoloanarrangementstosmooth consumptionsubjecttoendogenousdebtlimits,asinKehoeand Levine(1993). Creditagentswhodefaultareforeverexcludedfromtheloan marketandmustinsteadusecurrency. Futureinflationrateswillimpactthepayofftodefault. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS NATURE OF THE ENVIRONMENT Cashagentsareanonymoushouseholdswhomayonlyuse currencytosmoothincomefluctuations,asinBewley(1980).

The“unbanked.” Creditagentsmayenterintoloanarrangementstosmooth consumptionsubjecttoendogenousdebtlimits,asinKehoeand Levine(1993). Creditagentswhodefaultareforeverexcludedfromtheloan marketandmustinsteadusecurrency. Futureinflationrateswillimpactthepayofftodefault. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS NATURE OF THE ENVIRONMENT Cashagentsareanonymoushouseholdswhomayonlyuse currencytosmoothincomefluctuations,asinBewley(1980). Noclaimscanbeenforcedonthemorbythem.

Creditagentsmayenterintoloanarrangementstosmooth consumptionsubjecttoendogenousdebtlimits,asinKehoeand Levine(1993). Creditagentswhodefaultareforeverexcludedfromtheloan marketandmustinsteadusecurrency. Futureinflationrateswillimpactthepayofftodefault. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS NATURE OF THE ENVIRONMENT Cashagentsareanonymoushouseholdswhomayonlyuse currencytosmoothincomefluctuations,asinBewley(1980). Noclaimscanbeenforcedonthemorbythem. The“unbanked.”

Creditagentswhodefaultareforeverexcludedfromtheloan marketandmustinsteadusecurrency. Futureinflationrateswillimpactthepayofftodefault. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS NATURE OF THE ENVIRONMENT Cashagentsareanonymoushouseholdswhomayonlyuse currencytosmoothincomefluctuations,asinBewley(1980). Noclaimscanbeenforcedonthemorbythem. The“unbanked.” Creditagentsmayenterintoloanarrangementstosmooth consumptionsubjecttoendogenousdebtlimits,asinKehoeand Levine(1993).

Futureinflationrateswillimpactthepayofftodefault. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS NATURE OF THE ENVIRONMENT Cashagentsareanonymoushouseholdswhomayonlyuse currencytosmoothincomefluctuations,asinBewley(1980). Noclaimscanbeenforcedonthemorbythem. The“unbanked.” Creditagentsmayenterintoloanarrangementstosmooth consumptionsubjecttoendogenousdebtlimits,asinKehoeand Levine(1993). Creditagentswhodefaultareforeverexcludedfromtheloan marketandmustinsteadusecurrency.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS NATURE OF THE ENVIRONMENT Cashagentsareanonymoushouseholdswhomayonlyuse currencytosmoothincomefluctuations,asinBewley(1980). Noclaimscanbeenforcedonthemorbythem. The“unbanked.” Creditagentsmayenterintoloanarrangementstosmooth consumptionsubjecttoendogenousdebtlimits,asinKehoeand Levine(1993). Creditagentswhodefaultareforeverexcludedfromtheloan marketandmustinsteadusecurrency. Futureinflationrateswillimpactthepayofftodefault.

... anddirectlyselectsconsumptionvectorsforcreditagentswho mayeitheraccepttheirallocationsorbehavelikecashagentsin perpetuity. Theinflationtargetinthiseconomyissimilartoanoptimaltax subjecttoanincentiveconstraintasunderstoodbyMirrlees (1971). INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS THE MONETARY AUTHORITY, BRIEF VERSION Benevolentsocialplannerchoosesaconstantinflationrateat whichcashagentscantrade...

Theinflationtargetinthiseconomyissimilartoanoptimaltax subjecttoanincentiveconstraintasunderstoodbyMirrlees (1971). INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS THE MONETARY AUTHORITY, BRIEF VERSION Benevolentsocialplannerchoosesaconstantinflationrateat whichcashagentscantrade... ... anddirectlyselectsconsumptionvectorsforcreditagentswho mayeitheraccepttheirallocationsorbehavelikecashagentsin perpetuity.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS THE MONETARY AUTHORITY, BRIEF VERSION Benevolentsocialplannerchoosesaconstantinflationrateat whichcashagentscantrade... ... anddirectlyselectsconsumptionvectorsforcreditagentswho mayeitheraccepttheirallocationsorbehavelikecashagentsin perpetuity. Theinflationtargetinthiseconomyissimilartoanoptimaltax subjecttoanincentiveconstraintasunderstoodbyMirrlees (1971).

atransferofresourcesfromthecashsector,and areductioninthedefaultpayoffwhichbringsabouthigherdebt limits. ... andconfertwobenefitsoncreditagents: INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS COSTS AND BENEFITS OF POSITIVE INFLATION Positiveratesofinflationimposeataxoncashagents...

atransferofresourcesfromthecashsector,and areductioninthedefaultpayoffwhichbringsabouthigherdebt limits. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS COSTS AND BENEFITS OF POSITIVE INFLATION Positiveratesofinflationimposeataxoncashagents... ... andconfertwobenefitsoncreditagents:

areductioninthedefaultpayoffwhichbringsabouthigherdebt limits. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS COSTS AND BENEFITS OF POSITIVE INFLATION Positiveratesofinflationimposeataxoncashagents... ... andconfertwobenefitsoncreditagents: atransferofresourcesfromthecashsector,and

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS COSTS AND BENEFITS OF POSITIVE INFLATION Positiveratesofinflationimposeataxoncashagents... ... andconfertwobenefitsoncreditagents: atransferofresourcesfromthecashsector,and areductioninthedefaultpayoffwhichbringsabouthigherdebt limits.

Itwouldassign(c ,c )tohighincomeandlowincomecredit H L agents,andconsumption(x ,x )tothecorrespondingcash H L agents. Equivalenttolump-sumtaxesonsomeagentsandlump-sum subsidiestoothers. Becauseinflationisadistortionarytax,wedefineamodified planningproblem. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS INFLATION TARGETING AS A PLANNING PROBLEM Pureequal-treatmentplanningproblemwouldchooseaperiodic consumptionsequenceforeachagent.

Equivalenttolump-sumtaxesonsomeagentsandlump-sum subsidiestoothers. Becauseinflationisadistortionarytax,wedefineamodified planningproblem. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS INFLATION TARGETING AS A PLANNING PROBLEM Pureequal-treatmentplanningproblemwouldchooseaperiodic consumptionsequenceforeachagent. Itwouldassign(c ,c )tohighincomeandlowincomecredit H L agents,andconsumption(x ,x )tothecorrespondingcash H L agents.

Becauseinflationisadistortionarytax,wedefineamodified planningproblem. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS INFLATION TARGETING AS A PLANNING PROBLEM Pureequal-treatmentplanningproblemwouldchooseaperiodic consumptionsequenceforeachagent. Itwouldassign(c ,c )tohighincomeandlowincomecredit H L agents,andconsumption(x ,x )tothecorrespondingcash H L agents. Equivalenttolump-sumtaxesonsomeagentsandlump-sum subsidiestoothers.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS INFLATION TARGETING AS A PLANNING PROBLEM Pureequal-treatmentplanningproblemwouldchooseaperiodic consumptionsequenceforeachagent. Itwouldassign(c ,c )tohighincomeandlowincomecredit H L agents,andconsumption(x ,x )tothecorrespondingcash H L agents. Equivalenttolump-sumtaxesonsomeagentsandlump-sum subsidiestoothers. Becauseinflationisadistortionarytax,wedefineamodified planningproblem.

Next,givenπ,highincomecashagentschooseaperiodic consumptionvector(x ,x ) 0tomaximizestationary H L (cid:21) discountedutility 1 [u(x )+βu(x )] (3) 1 β2 H L (cid:0) subjectto x 1+α, (4) H (cid:20) x +πx =1+α+π(1 α), (5) H L (cid:0) u(x )+βu(x ) u(1+α)+βu(1 α) (6) H L (cid:21) (cid:0) (1)nonnegativecurrency;(2)moneybalancesareusedupto smoothconsumptioninlowincomedates;(3)agentscan renouncemoneyandconsumeendowments. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS MODIFIED PLANNING PROBLEM First,themonetaryauthoritysetsaconstantinflationfactorπ.

(1)nonnegativecurrency;(2)moneybalancesareusedupto smoothconsumptioninlowincomedates;(3)agentscan renouncemoneyandconsumeendowments. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS MODIFIED PLANNING PROBLEM First,themonetaryauthoritysetsaconstantinflationfactorπ. Next,givenπ,highincomecashagentschooseaperiodic consumptionvector(x ,x ) 0tomaximizestationary H L (cid:21) discountedutility 1 [u(x )+βu(x )] (3) 1 β2 H L (cid:0) subjectto x 1+α, (4) H (cid:20) x +πx =1+α+π(1 α), (5) H L (cid:0) u(x )+βu(x ) u(1+α)+βu(1 α) (6) H L (cid:21) (cid:0)

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS MODIFIED PLANNING PROBLEM First,themonetaryauthoritysetsaconstantinflationfactorπ. Next,givenπ,highincomecashagentschooseaperiodic consumptionvector(x ,x ) 0tomaximizestationary H L (cid:21) discountedutility 1 [u(x )+βu(x )] (3) 1 β2 H L (cid:0) subjectto x 1+α, (4) H (cid:20) x +πx =1+α+π(1 α), (5) H L (cid:0) u(x )+βu(x ) u(1+α)+βu(1 α) (6) H L (cid:21) (cid:0) (1)nonnegativecurrency;(2)moneybalancesareusedupto smoothconsumptioninlowincomedates;(3)agentscan renouncemoneyandconsumeendowments.

Equaltreatmentofhighincomeandlowincomehouseholds meansthatthediscountedutilitiesareweightedequally. This givesthewelfarefunctionabove. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS MORE ON THE MODIFIED PLANNING PROBLEM Letx (π)andx (π)solvethepreviousproblem. Givenπ,the H L plannernowchoosesconsumptionvalues(c ,c ) 0forcredit H L (cid:21) householdstomaximizetheequal-treatmentwelfarefunction 1 [u(c )+u(c )] (7) 1 β2 H L (cid:0) subjecttotheresourceconstraint λ(c +c )+(1 λ)[x (π)+x (π)] =2, (8) H L H L (cid:0) andtheparticipationconstraint u(c )+βu(c ) u[x (π)]+βu[x (π)]. (9) H L H L (cid:21)

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS MORE ON THE MODIFIED PLANNING PROBLEM Letx (π)andx (π)solvethepreviousproblem. Givenπ,the H L plannernowchoosesconsumptionvalues(c ,c ) 0forcredit H L (cid:21) householdstomaximizetheequal-treatmentwelfarefunction 1 [u(c )+u(c )] (7) 1 β2 H L (cid:0) subjecttotheresourceconstraint λ(c +c )+(1 λ)[x (π)+x (π)] =2, (8) H L H L (cid:0) andtheparticipationconstraint u(c )+βu(c ) u[x (π)]+βu[x (π)]. (9) H L H L (cid:21) Equaltreatmentofhighincomeandlowincomehouseholds meansthatthediscountedutilitiesareweightedequally. This givesthewelfarefunctionabove.

ThisSWFassignsequalweightstomembersofthesamegroup butpotentiallydifferentweightstodifferentgroups. AstrictlyutilitarianSWFwouldhaveequalweightsforall,that is,δ = λ. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS MORE ON THE MODIFIED PLANNING PROBLEM Ifc (π)andc (π)solvethepreviousproblemforagiven H L π >0,theplannerselectsthestationaryinflationfactorπto maximizethesocialwelfarefunction (π,δ) = δ u[c (π)]+u[c (π)] H L W f g +(1 δ) u[x (π)]+u[x (π)] . (10) H L (cid:0) f g

AstrictlyutilitarianSWFwouldhaveequalweightsforall,that is,δ = λ. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS MORE ON THE MODIFIED PLANNING PROBLEM Ifc (π)andc (π)solvethepreviousproblemforagiven H L π >0,theplannerselectsthestationaryinflationfactorπto maximizethesocialwelfarefunction (π,δ) = δ u[c (π)]+u[c (π)] H L W f g +(1 δ) u[x (π)]+u[x (π)] . (10) H L (cid:0) f g ThisSWFassignsequalweightstomembersofthesamegroup butpotentiallydifferentweightstodifferentgroups.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS MORE ON THE MODIFIED PLANNING PROBLEM Ifc (π)andc (π)solvethepreviousproblemforagiven H L π >0,theplannerselectsthestationaryinflationfactorπto maximizethesocialwelfarefunction (π,δ) = δ u[c (π)]+u[c (π)] H L W f g +(1 δ) u[x (π)]+u[x (π)] . (10) H L (cid:0) f g ThisSWFassignsequalweightstomembersofthesamegroup butpotentiallydifferentweightstodifferentgroups. AstrictlyutilitarianSWFwouldhaveequalweightsforall,that is,δ = λ.

Weallowlump-sumincometransfers. TheplannerthenmaximizestheSWFsubjecttotheeconomy’s resourceconstraint. Thisgivesafirstbestsolutionwithπ = β,RN =1,andsmooth consumptionforbothgroupsofagents. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS OPTIMUM INFLATION WITHOUT INCENTIVE CONSTRAINTS Tobuildupintuition,wefirstsolvetheplanner’sproblem ignoringforthemomenttheincentiveconstraints.

TheplannerthenmaximizestheSWFsubjecttotheeconomy’s resourceconstraint. Thisgivesafirstbestsolutionwithπ = β,RN =1,andsmooth consumptionforbothgroupsofagents. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS OPTIMUM INFLATION WITHOUT INCENTIVE CONSTRAINTS Tobuildupintuition,wefirstsolvetheplanner’sproblem ignoringforthemomenttheincentiveconstraints. Weallowlump-sumincometransfers.

Thisgivesafirstbestsolutionwithπ = β,RN =1,andsmooth consumptionforbothgroupsofagents. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS OPTIMUM INFLATION WITHOUT INCENTIVE CONSTRAINTS Tobuildupintuition,wefirstsolvetheplanner’sproblem ignoringforthemomenttheincentiveconstraints. Weallowlump-sumincometransfers. TheplannerthenmaximizestheSWFsubjecttotheeconomy’s resourceconstraint.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS OPTIMUM INFLATION WITHOUT INCENTIVE CONSTRAINTS Tobuildupintuition,wefirstsolvetheplanner’sproblem ignoringforthemomenttheincentiveconstraints. Weallowlump-sumincometransfers. TheplannerthenmaximizestheSWFsubjecttotheeconomy’s resourceconstraint. Thisgivesafirstbestsolutionwithπ = β,RN =1,andsmooth consumptionforbothgroupsofagents.

Theplannermustnowchoose(π,c ,c )tosolvethemodified H L planningproblem,butstillignoringtheincentiveconstraints. Supposeδ =1,nowelfareweightonthecashcommunity. Then theplannerchoosesmaximalseigniorageπ˜ andsmoothsthe consumptionofthecreditcommunitycompletely. Supposeδ =0,nowelfareweightonthecreditcommunity. Then theplannerwillpushtheinflationfactorasclosetozeroas possible. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS SECOND BEST Supposethattheplannercannotimposealump-sumtaxonany agentbutmustinsteaduseinflationordeflationandredistribute theresultingseignoragefromonegrouptoanother.

Supposeδ =1,nowelfareweightonthecashcommunity. Then theplannerchoosesmaximalseigniorageπ˜ andsmoothsthe consumptionofthecreditcommunitycompletely. Supposeδ =0,nowelfareweightonthecreditcommunity. Then theplannerwillpushtheinflationfactorasclosetozeroas possible. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS SECOND BEST Supposethattheplannercannotimposealump-sumtaxonany agentbutmustinsteaduseinflationordeflationandredistribute theresultingseignoragefromonegrouptoanother. Theplannermustnowchoose(π,c ,c )tosolvethemodified H L planningproblem,butstillignoringtheincentiveconstraints.

Supposeδ =0,nowelfareweightonthecreditcommunity. Then theplannerwillpushtheinflationfactorasclosetozeroas possible. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS SECOND BEST Supposethattheplannercannotimposealump-sumtaxonany agentbutmustinsteaduseinflationordeflationandredistribute theresultingseignoragefromonegrouptoanother. Theplannermustnowchoose(π,c ,c )tosolvethemodified H L planningproblem,butstillignoringtheincentiveconstraints. Supposeδ =1,nowelfareweightonthecashcommunity. Then theplannerchoosesmaximalseigniorageπ˜ andsmoothsthe consumptionofthecreditcommunitycompletely.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS SECOND BEST Supposethattheplannercannotimposealump-sumtaxonany agentbutmustinsteaduseinflationordeflationandredistribute theresultingseignoragefromonegrouptoanother. Theplannermustnowchoose(π,c ,c )tosolvethemodified H L planningproblem,butstillignoringtheincentiveconstraints. Supposeδ =1,nowelfareweightonthecashcommunity. Then theplannerchoosesmaximalseigniorageπ˜ andsmoothsthe consumptionofthecreditcommunitycompletely. Supposeδ =0,nowelfareweightonthecreditcommunity. Then theplannerwillpushtheinflationfactorasclosetozeroas possible.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS MORE ON SECOND BEST Thesecondbesttradesoffthesetwoextremecases. THEOREM Thesecondbestoptimumallocationunderautilitariansocialwelfare functionsatisfies(c ,c ,x ,x ) = (c ,c ,x (π ),x (π )). Itis H L H L (cid:3)(cid:3) (cid:3)(cid:3) H (cid:3)(cid:3) L (cid:3)(cid:3) supportedbya“modifiedFriedmanrule”forsomeinflationfactor π (β,1),andanominalyieldsuchthatRN = π /β >1. (cid:3)(cid:3) (cid:3)(cid:3) 2 PROOF. Seetheappendix.

Calltheassociatedinflationfactorπ¯. Perhapsmorecontroversial? “Themarketforunsecuredcreditcanbemadetoworkperfectly.” A2. Incomesharescannotbe“toosmooth.” A3. Itiswithinthepowerofthecentralplannertolowertherate ofreturnfacingusersofcashtothepointwheretheincentive constraintoncreditusersbecomesslack. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS KEY ASSUMPTIONS A1. Incomesharescannotbe“toovariable.”

Calltheassociatedinflationfactorπ¯. Perhapsmorecontroversial? “Themarketforunsecuredcreditcanbemadetoworkperfectly.” A3. Itiswithinthepowerofthecentralplannertolowertherate ofreturnfacingusersofcashtothepointwheretheincentive constraintoncreditusersbecomesslack. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS KEY ASSUMPTIONS A1. Incomesharescannotbe“toovariable.” A2. Incomesharescannotbe“toosmooth.”

Calltheassociatedinflationfactorπ¯. Perhapsmorecontroversial? “Themarketforunsecuredcreditcanbemadetoworkperfectly.” INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS KEY ASSUMPTIONS A1. Incomesharescannotbe“toovariable.” A2. Incomesharescannotbe“toosmooth.” A3. Itiswithinthepowerofthecentralplannertolowertherate ofreturnfacingusersofcashtothepointwheretheincentive constraintoncreditusersbecomesslack.

Perhapsmorecontroversial? “Themarketforunsecuredcreditcanbemadetoworkperfectly.” INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS KEY ASSUMPTIONS A1. Incomesharescannotbe“toovariable.” A2. Incomesharescannotbe“toosmooth.” A3. Itiswithinthepowerofthecentralplannertolowertherate ofreturnfacingusersofcashtothepointwheretheincentive constraintoncreditusersbecomesslack. Calltheassociatedinflationfactorπ¯.

“Themarketforunsecuredcreditcanbemadetoworkperfectly.” INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS KEY ASSUMPTIONS A1. Incomesharescannotbe“toovariable.” A2. Incomesharescannotbe“toosmooth.” A3. Itiswithinthepowerofthecentralplannertolowertherate ofreturnfacingusersofcashtothepointwheretheincentive constraintoncreditusersbecomesslack. Calltheassociatedinflationfactorπ¯. Perhapsmorecontroversial?

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS KEY ASSUMPTIONS A1. Incomesharescannotbe“toovariable.” A2. Incomesharescannotbe“toosmooth.” A3. Itiswithinthepowerofthecentralplannertolowertherate ofreturnfacingusersofcashtothepointwheretheincentive constraintoncreditusersbecomesslack. Calltheassociatedinflationfactorπ¯. Perhapsmorecontroversial? “Themarketforunsecuredcreditcanbemadetoworkperfectly.”

Part(b)intuition. Asmallincreaseintheinflationtaxcreatesa creditmarketwhereonewouldotherwisenotexist. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS LEMMA 2 LEMMA Define (π,δ) = ∂ /∂π.Then(a) (π,δ) <0 π π (π,δ) W [π¯,π˜] [0, W λ],and(b)lim W (π,δ) = +∞whenπ π 1 π 8 2 (cid:2) ! W convergesfromabove. Part(a)intuition. Toraiseπaboveπ¯ doesnotimprovetheability oftheplannertosmooththeconsumptionofthecredit communityanyfurther. Doingsomerelytransfersincomefrom thecashcommunity. Thistransferwillreducesocialwelfare exceptwhenδ > λ.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS LEMMA 2 LEMMA Define (π,δ) = ∂ /∂π.Then(a) (π,δ) <0 π π (π,δ) W [π¯,π˜] [0, W λ],and(b)lim W (π,δ) = +∞whenπ π 1 π 8 2 (cid:2) ! W convergesfromabove. Part(a)intuition. Toraiseπaboveπ¯ doesnotimprovetheability oftheplannertosmooththeconsumptionofthecredit communityanyfurther. Doingsomerelytransfersincomefrom thecashcommunity. Thistransferwillreducesocialwelfare exceptwhenδ > λ. Part(b)intuition. Asmallincreaseintheinflationtaxcreatesa creditmarketwhereonewouldotherwisenotexist.

Theoutcomeofanydeflationisthatmoneyhasahigherpayoff thancredit. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS LEMMA 3 LEMMA (π,δ)isnotdefinedforπ <1.Itisdecreasinginπforπ (π˜,1/R¯) a W ndconstantforπ 1/R¯. 2 (cid:21) Deflationviolatestheparticipationconstraintforhighincome credithouseholds.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS LEMMA 3 LEMMA (π,δ)isnotdefinedforπ <1.Itisdecreasinginπforπ (π˜,1/R¯) a W ndconstantforπ 1/R¯. 2 (cid:21) Deflationviolatestheparticipationconstraintforhighincome credithouseholds. Theoutcomeofanydeflationisthatmoneyhasahigherpayoff thancredit.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS THEOREM 4 THEOREM SupposeassumptionsA1,A2,andA3hold,and0< δ λ.Thenthe optimuminflationfactorisπ?(δ) >1andtheassociate (cid:20) dnominalinterest yield,RN (π?(δ),π?(δ)/β),isevenhigher. 2

U.S.A.:Onetotwopercent. RepublicofSouthAfrica:Threetosixpercent. Mainconclusion: independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets. Soundslike“comfortzones”articulatedbycentralbankers. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS CONCLUSIONS AND EXTENSIONS Inthispaper,theoptimalinflationtargetshouldstrikeabalance betweenthedeadweightlossfrominflationandthepotential improvementincreditmarketconditions.

U.S.A.:Onetotwopercent. RepublicofSouthAfrica:Threetosixpercent. Soundslike“comfortzones”articulatedbycentralbankers. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS CONCLUSIONS AND EXTENSIONS Inthispaper,theoptimalinflationtargetshouldstrikeabalance betweenthedeadweightlossfrominflationandthepotential improvementincreditmarketconditions. Mainconclusion: independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets.

RepublicofSouthAfrica:Threetosixpercent. Soundslike“comfortzones”articulatedbycentralbankers. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS CONCLUSIONS AND EXTENSIONS Inthispaper,theoptimalinflationtargetshouldstrikeabalance betweenthedeadweightlossfrominflationandthepotential improvementincreditmarketconditions. Mainconclusion: independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets. U.S.A.:Onetotwopercent.

Soundslike“comfortzones”articulatedbycentralbankers. INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS CONCLUSIONS AND EXTENSIONS Inthispaper,theoptimalinflationtargetshouldstrikeabalance betweenthedeadweightlossfrominflationandthepotential improvementincreditmarketconditions. Mainconclusion: independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets. U.S.A.:Onetotwopercent. RepublicofSouthAfrica:Threetosixpercent.

INTRODUCTION MAINIDEAS ENVIRONMENT PLANNINGPROBLEMS OPTIMUMINFLATION THEROLEOFINCENTIVECONSTRAINTS CONCLUSIONS CONCLUSIONS AND EXTENSIONS Inthispaper,theoptimalinflationtargetshouldstrikeabalance betweenthedeadweightlossfrominflationandthepotential improvementincreditmarketconditions. Mainconclusion: independentcentralbankswillsetlowpositive inflationtargetsineconomiesthatpossesshighlydeveloped financialmarkets. U.S.A.:Onetotwopercent. RepublicofSouthAfrica:Threetosixpercent. Soundslike“comfortzones”articulatedbycentralbankers.