The Optimal Rate of Inflation in an Open Economy

Abstract

This paper constructs an empirically implementable two country New Open Economy Macroeconomic (NOEM) model, and analyzes the long-term monetary policy represented by the optimal rate of inflation. It is a well known fact that zero inflation is optimal in the closed economy of a New Keynesian DSGE model as the inefficiency of price stickiness can be eliminated with zero inflation. This study investigates how the open economy environment affects the optimality of zero inflation. Under a managed floating exchange rate system, an increase in the degree of trade openness has the potential to raise the optimal rate of inflation significantly, while this effect disappears under a complete floating exchange rate system. We also try to find the Nash equilibrium of target inflation between the two economies, and find that the target inflation rates are positive in both economies in equilibrium.