Nominal rigidities and the optimal rate of inflation

Abstract

Inflation may enhance the efficiency of the price system in the presence of nominal rigidities. For the price system to function efficiently, nominal prices need to adjust both to real and nominal shocks for relative prices to disseminate the appropriate signals. Since the incentive for price setters to change nominal prices depends not only on the costs of changing prices but also on the realized shocks, it follows that the rate of inflation may affect the incentive to change nominal prices. The higher the rate of inflation, the larger the incentive to change nominal prices, and in the presence of real shocks requiring adjustment of relative prices, this can lead to a better functioning price system. Empirical evidence supports that nominal rigidities are more prevalent at low rates of inflation. It follows that there can be welfare costs of targeting inflation at too low a level.