No. 259 Labor-Market Frictions and Optimal Inflation

By Mikael Carlsson and Andreas Westermark

MARCH 2012

Abstract

In central theories of monetary non-neutrality the Ramsey optimal inflation rate varies between the negative of the real interest rate and zero. This paper explores how the interaction of nominal wage and search and matching frictions affect the policy prescription. We show that adding the combination of such frictions to the canonical monetary model can generate an optimal inflation rate that is significantly positive. Specifically, for a standard U.S. calibration, we find a Ramsey optimal inflation rate of 1.11 percent per year.

Keywords:

Optimal Monetary Policy, Inflation, Labor-market Distortions.

JEL classification:

E52, H21, J60.