Front Matter Page
Central Asia Department
Contents
Summary
I. Introduction
II. The Long-Run Rate of Inflation and the Variability of Output
III. Asymmetries in Output
IV. Empirical Relevance
V. Conclusion
Text Tables
1. Parameter Values
2. Summary statistics for Output in Stochastic Simulations at Alternative Trend Inflation Rates
Appendix I. Characteristics of the Solution for Output in the Nonlinear Model
Appendix II. Parameter Values for the U.S. Economy
Figures
1. Impulse Response of Output to Positive Monetary and Goods Market Shocks at Alternative Long Run Rates of Inflation
2. Variance of Output as a Function of the Long Run Rate of Inflation
3. Intrinsic Dynamics of Output During Expansions and Contractions
4. Simulated Effect of 1 Percent Positive and Negative Shocks at Annual Trend Inflation Rates of 0 and 10 Percent
5. Distribution of Output around Capacity
References
Summary
This paper examines the effects of the choice of the long-run or trend inflation rate on the magnitude and form of the business cycle. The distribution of output around capacity is investigated assuming that money demand becomes increasingly responsive to changes in the nominal interest rate as the level of interest rate falls so that nominal interest rates are bounded by a zero floor. When fluctuations in output result primarily from disturbances to the money market, the variance of output is an increasing function of the trend inflation rate. When they result primarily from disturbances to the goods market, however, the variance of output is a decreasing function of the trend inflation rate. If both disturbances are significant, there exists a critical nonzero trend inflation rate that minimizes the variance of output.
The response of output to shocks is asymmetric. Contractions in output are more severe than expansions, but shorter-lived in that output returns to capacity faster during contractions than in expansions. As a result, the distribution of output is skewed, with the direction of skewness depending on the relative importance of the two effects. The extent of asymmetry in the output response is a decreasing function of the trend inflation rate.
Simulations with representative parameter values for the U.S. economy suggest that at very low rates of inflation, increases in the inflation rate could significantly lower the variance of output. Over this range of inflation rates, therefore, there is a trade-off between price stability and the stability of output. Improvements in price stability come only at the expense of increased output variability. At higher rates of inflation, however, increases in the inflation rate lead to increases in the variability of output. In general, therefore, some inflation is optimal.