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The Case for Price Stability

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The Case for Price Stability Working Paper Series This paper can be downloaded without charge from: http://www.richmondfed.org/publications/ The Case for Price Stability Marvin Goodfriend Robert G. King¤ Federal Reserve Bank of Richmond Working Paper No. 01-02 April 2001 JEL Nos. E3, E5, E6 Keywords: in‡ation persistence, markup constancy, neutral monetary policy, new neoclassical synthesis, optimal monetary and …scal policy, price level stability, real business cycles, sticky wages and prices Abstract Reasoning within the New Neoclassical Synthesis (NNS) we previously recom- mended that price stability should be the primary objective of monetary policy. We called this a neutral policy because it keeps output at its potential, de…ned as the out- come of an imperfectly competitive real business cycle model with a constant markup of price over marginal cost. We explore the foundations of neutral policy more fully in this paper. Using the principles of public …nance, we derive conditions under which markup constancy is optimal monetary policy. Price stability as the primary policy objective has been criticized on a number of grounds which we evaluate in this paper. We show that observed in‡ation persistence in U.S. time series is consistent with the absence of structural in‡ation stickiness as is the case in the benchmark NNS economy. We consider reasons why monetary policy might depart from markup constancy and price stability, but we argue that optimal departures are likely to be minor. Finally, we argue that the presence of nominal wage stickiness in labor markets does not undermine the case for neutral policy and price stability. ¤Goodfriend is Senior Vice President and Policy Advisor at the Federal Reserve Bank of Richmond. King is Professor of Economics at Boston University, an NBER research associate, and a consultant to the FRB Richmond. The paper was prepared for the First ECB Central Banking Conference, Why Price Stability?, Frankfurt, Germany, November 2000. We thank our discussants Jordi Gali and Guido Tabellini for valuable comments. Our opinions do not necessarily represent those of the Federal Reserve Bank of Richmond or the Federal Reserve System. W?|hL_ U|L? *_?} L? ?i U*@ttU@* 4@UhLiUL?L4Ut @?_ hi@* Mt?itt U)U*i E+ @?@*)ttc 4@UhLiUL?L4U 4L_i*t Lu |i i iLU*@ttU@* 5)?|itt E5 ?ULhTLh@|i ? |ih|i4TLh@* LT|43@|L? @?_ h@|L?@* i TiU|@|L?t ?|L _)?@4U 4@UhLiUL?L4U 4L_i*t*_?} L? i ki)?it@? iUL?L4Utc |i ?i t)?|itt 4L_i*t ?ULhTL h@|i 4TihuiU| UL4Ti||L? @?_ ULt|*) ThUi @_t|4i?|w!i |i + ThL}h@4c |i i iLU*@ttU@* 5)?|itt tii!t |L _ii*LT ^@?||@|i 4L_i*t Lu iUL?L4U U|@|L?t Ai UL4M?@|L? Lu h@|L?@* uLh@h_*LL!?} ThUi ti||?}c 4L?LTL*t|U UL4 Ti||L?c @?_ + UL4TL?i?|t ? Mi?U4@h! 5 4L_i*t ThL_it UL?t_ih@M*i }_@?Ui uLh 4L?i|@h) TL*U)c @t i ThiLt*) t|hitti_ ? BLL_uhi?_ @?_ k?} Ebb. 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