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Does stabilizing inflation contribute to stabilizing economic activity? a speech at the East Carolina University's Beta Gamma Sigma Distinguished Lecture Series, Greenville, North Carolina, February 25, 2008

Authors
Disciplines
  • Economics

Abstract

Why price stability? Abstract Reasoning within the New Neoclassical Synthesis (NNS) we previously recommended that price stability should be the primary objective of monetary policy. We called this a neutral policy because it keeps output at its potential, defined as the outcome of an imperfectly competitive real business cycle model with a constant markup of price over marginal cost. We explore the foundations of neutral policy more fully in this paper. Using the principles of public finance, we derive conditions under which markup constancy is optimal monetary policy. Price stability as the primary policy objective has been criticized on a number of grounds which we evaluate in this paper. We show that observed inflation persistence in U.S. time series is consis- tent with the absence of structural inflation stickiness as is the case in the benchmark NNS econo- my. We consider reasons why monetary policy might depart from markup constancy and price stability, but we argue that optimal departures are likely to be minor. Finally, we argue that the presence of nominal wage stickiness in labor markets does not undermine the case for neutral policy and price stability. 1. Introduction Building on new classical macroeconomics and real business cycle (RBC) analysis, macroeconomic models of the New Neoclassical Synthesis (NNS) incorporate intertem- poral optimization and rational expectations into dynamic macroeconomic models. Building on New Keynesian economics, the new synthesis models incorporate imperfect competition and costly price adjustment. Like the RBC program, the New Neoclassical Synthesis seeks to develop quantitative models of economic fluctuations. The combination of rational forward-looking price setting, monopolistic competition, and RBC components in benchmark NNS models provides considerable guidance for monetary policy, as we previously stressed in Goodfriend and King (1997).1 Monetary policy must respect the RBC determinants of real economic activity on average ov

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