By Hasan Bakhshi, Ben Martin and Tony Yates
Inflation makes it costly to hold non-interest-bearing cash and reserves. For a long time economists have known that this cost could be eliminated if monetary policy acted to bring about a steady state of zero nominal interest rates, where there is no penalty to holding cash. (In such a regime, inflation would be equal to the negative of the real interest rate, the rate that equalises the return to holding cash and a risk-free real asset.) Since then a number of researchers have sought to quantify how much time (and utility) is thrown away as nominal interest rates rise above zero. But why all this effort, when the ‘optimal’ inflation rate has been worked out? The interest stems from the apparent consensus in modern monetary regimes that policy should aim at a positive rate of inflation. Those regimes are predicated on the notion of setting the costs of staying away from the ‘Friedman rule’ on the one hand against the costs of lowering inflation further on the other. These costs of lowering inflation are highly uncertain and difficult to model coherently, but could be important. Leaving aside measurement problems, researchers have examined whether low inflation could cause problems if nominal wages or prices are downwardly rigid. And they have also sought to quantify the costs of monetary policy becoming impotent as nominal rates hit the zero bound in regimes of very low inflation. Models tractable enough to calculate the costs of inflation are typically simplified to the point where the economic behaviours that could generate these ‘benefits’ of positive inflation are not included. So the interest in calculating the welfare cost of positive inflation is a pragmatic one. Absent an all-singing, all-dancing model that includes a zero bound and downward nominal frictions, take a monetary general equilibrium model, calculate the costs of positive inflation, and balance these in an informal way against the ‘benefits’.