Optimal long-run inflation rate in an open economy

Abstract

I analyze the long-run optimal inflation rate in the sticky price model with trend inflation and a two-country, two-good Ricardian trade structure. As in the closed-economy model, price stickiness effectively reduces an industry’s productivity under trend inflation. Contrary to the standard closed-economy models in which the optimal inflation rate is approximately zero, the model implies that the optimal rate is positive under certain conditions. Welfare gains come from manipulations of the terms of trade, and are hence associated with the loss of the trade partner. If the partner counter-acts, the allocation can be worse than what would occur under autarky.