Welfare costs of shifting trend inflation

Abstract

This paper studies the welfare consequences of exogenous variations in trend inflation in a New Keynesian economy. Consumption and leisure respond asymmetrically to a rise and a decline in trend inflation. As a result, an increase in the variance of shocks to the trend inflation process decreases welfare not only by increasing the volatilities of consumption and leisure, but also by decreasing their average levels. I find that the welfare cost of drifting trend inflation is modest and that it comes mainly from reduced average levels of consumption and leisure, not from their increased volatilities. JEL: C63, E31, E52

Welfare consequences of inconsistent monetary policy implementation in Vietnam

“…A reduction in the steady-state and mean values and a rise in the volatility values of consumption and leisure are sources of welfare distortions when a central bank sets up a constant positive level of trend inflation. The results are aligned with those of Amano et al (2007) and Nakata (2014). The top panel of Figure 4 represents changes in welfare costs with respect to a rise in the trend inflation level and the bottom panel provides reasons to explain these changes.…”

“…The other strand is related to the model with shifting trend inflation. By employing the second perturbation approximation method suggested by Kim, Kim, Sims, and Schaumburg (2008), Nakata (2014) attempts to quantify the welfare consequences of shifting trend inflation. In his model, he argues that the negative impacts of exogenous variations in trend inflation are transmitted into the economy solely by the staggered price contracts.…”

“…With this consideration, he shows the trivial welfare costs of shifting trend inflation. In this study, we follow an approach similar to that used in Nakata (2014) to measure the welfare consequences of shifting trend inflation. However, we incorporate an additional channel that trend inflation distorts the relative allocation of labors across households through a staggered wage contract, as discussed by Erceg, Henderson, and Levin (2000), thus causing changes in welfare.…”

“…To model the substantial rise in inflation, many authors, such as Kozicki and Tinsley (2001), Ireland (2007), Cogley, Primiceri, and Sargent (2009) and Nakata (2014) have employed a highly persistent trend inflation process to depict slow changes in implicit inflation targets 1 set by a central bank. This adoption implies a lack of commitment to a fixed inflation target or a tendency of the central bank to let inflation rise.…”

“…This adoption implies a lack of commitment to a fixed inflation target or a tendency of the central bank to let inflation rise. By using this idea, authors show the necessity for studies on shifting trend inflation 2 , for example, the study illustrating the implications for the term structure of interest rate by Kozicki and Tinsley (2001), that on the consequences for output and inflation by Ireland (2007), the research on implications for the predictability of inflation by Cogley et al (2009), and the study on welfare consequences by Nakata (2014). However, the literature has mostly considered one form of rigiditiesthe sticky-price model with shifting trend inflation.…”