The Comeback of Inflation as an Optimal Public Finance Tool17-12-2013
The authors challenge the widely held belief that New-Keynesian models cannot predict optimal positive inflation rates. In fact these are justified by the Phelps argument that monetary financing can alleviate the burden of distortionary taxation. This result obtains because, in contrast with previous contributions, the model accounts for public transfers as a component of fiscal outlays.
The paper also contradicts the view that the Ramsey policy should minimize inflation volatility and induce near-random walk dynamics of public debt in the long-run. In fact it should instead stabilize debt-to-GDP ratios in order to mitigate steady-state distortions.
These results thus provide theoretical support to policy-oriented analyses which call for a reversal of debt accumulated in the aftermath of the 2008 financial crisis. The paper has far reaching implications for monetary and fiscal policy design in the EMU. First, the concept of price stability should be defined within the framework outlined above. The ECB statute is based on strict separation of roles between fiscal and monetary policies. Previous research unambiguously supported this approach. The paper establishes new theoretical results that call for a reconsideration of the issue.
Further RASTANEWS research shall provide an empirical assessment of the EMU optimal inflation rate. One may well expect that this will be positive, possibly above the ECB official target. In addition, given the within-EMU dispersion of public-expenditure-to-GDP ratios, important cross-country differences are likely to emerge about the optimal inflation rate. Such differences might not mirror the standard core-periphery divide. Second, the ECB monetary policy should be explicitly coordinated with the EMU global fiscal stance, and the latter should not be simply related to long-run debt stabilization. Further RASTANEWS research shall assess the implications of this result for EMU macroeconomic policies.