The proposal aims to shed light on whether a reduction in trend inflation would raise the average level of real economic activity in an economy, or reduce its variability. Neither mainstream economic theory nor existing empirical studies offer much support for the proposition. Indeed some economists argue that reducing the trend rate of inflation too close to zero worsens economic performance because of downward nominal wage rigidity and the zero lower bound on nominal interest rates. The research proposed here goes outside the mainstream to investigate whether inflation affects economic performance by impeding the economy's coordination mechanisms. The research will use agent based computational economics, which is a set of techniques for studying a complex adaptive system involving many interacting agents with exogenously given behavioral rules. Instead of modeling the system as if everyone's actions and beliefs were coordinated in advance with everyone else's, as in rational expectations theory, the approach assumes simple behavioral rules and allows a coordinated equilibrium to be a possibly emergent property of the system itself.
The specific model used will be a variant of one developed elsewhere by the investigator which has been shown to be capable of generating the institutions of monetary exchange endogenously and to exhibit a business-cycle propagation mechanism with time-series characteristics much like those exhibited by GDP data in the US. The research will modify this model by adding bonds and fiat money, and introducing a central bank that follows a Taylor rule by making the rate of interest depend on inflation and output. The model will be calibrated and then simulated many times under different values of the inflation target implicit in the Taylor rule, to see how that target affects the average level and variance of GDP.
Broader impacts Understanding the costs and benefits of inflation is of utmost importance to the successful conduct of monetary policy. Many central banks around the world are following a narrowly focused policy of inflation-targeting, on the grounds that controlling inflation at a low rate is the best way to promote consistently high levels of real economic activity. It is therefore of utmost importance that economists explore every avenue to test whether in fact trend inflation affects real performance. Mainstream economics seems to indicate otherwise, but many central bankers and economists suspect that this is a weakness of mainstream theory, not of the proposition itself. Thus the present research is being undertaken with the hope that it could ultimately contribute to better monetary policy.
