Low Inflation or Price Stability? A Look at the Issues

Abstract

This paper examines whether monetary authorities should aim for low inflation or price stability. It first outlines and assesses many of the costs of inflation. Some of these, such as the distortionary effect upon the tax system, have been shown to involve significant welfare costs, even at very low inflation rates. When a variety of estimates of the transitional costs of moving to price stability are set against the permanent benefits of getting there, the evidence strongly favours the objective of stable prices. Some commentators argue, however, that there may be permanent costs associated with price stability, such as higher equilibrium rates of unemployment and less effective monetary policy. These arguments are not short of their critics, however, who suggest that such costs either do not exist, or are likely to be unimportant in practice. Overall, it is not possible, given the current state of economic knowledge, to arrive at a definite value for the optimal rate of inflation, although the evidence reviewed in this paper suggests that price stability may be optimal.