The Optimal Inflation Rate and Firm-Level Productivity Growth

Empirical data show that firms tend to improve their ranking in the productivity distribution over time. A sticky-price model with firm-level productivity growth fits this data and predicts that the optimal long-run inflation rate is positive and between 1.5% and 2% per year. In contrast, the standard sticky-price model cannot fit this data and predicts optimal long-run inflation near zero. Despite positive long-run inflation, the Taylor principle ensures determinacy in the model with firm-level productivity growth, and optimal inflation stabilization policies are standard. In a two-sector extension of this model, the optimal long-run inflation rate weights the sector with the stickier prices more heavily.