Journal of Monetary Economics: Koki Oikawa, Kozo Ueda

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ARTICLE IN PRESS [m3Gsc;July 28, 2018;10:29]

Journal of Monetary Economics 0 0 0 (2018) 1–12
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Journal of Monetary Economics

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The optimal inflation rate under Schumpeterian growthR

Koki Oikawa a,∗, Kozo Ueda b
a
School of Social Sciences, Waseda University, 1-6-1 Nishiwaseda Shinjuku-ku, Tokyo 169-8050, Japan
b
School of Political Science and Economics, Waseda University, Tokyo, Japan
a r t i c l e i n f o a b s t r a c t
Article history: To analyze the relationship between inflation and economic growth, we construct an en-
Received 7 April 2015 dogenous growth model with creative destruction, incorporating sticky prices due to menu
Revised 12 July 2018
costs. Price changes reduce the reward for innovation and thus lower the frequency of cre-
Accepted 16 July 2018
ative destruction. Central banks can maximize the growth rate by setting their inflation
Available online xxx
target at the negative of a fundamental growth rate. While the optimal inflation rate may
JEL classification: be greater than the growth-maximizing inflation rate, our calibrated model shows that the
E31 optimal inflation rate is close to the growth-maximizing inflation rate and that a deviation
E58 from the optimal level has sizable impacts.
O33
© 2018 Elsevier B.V. All rights reserved.
O41
Keywords:
Creative destruction
Menu cost
New Keynesian
Monetary policy
1. Introduction
Sustained economic growth is one of the goals of central banks.1 However, only a handful of theoretical works exist on
the impact of inflation on economic growth. This study attempts to fill this gap by constructing an innovation-driven endoge-
nous growth model featuring sticky prices. More specifically, the model combines the standard menu cost model formulated
by Sheshinski and Weiss (1977) and the standard quality ladder model formulated by Grossman and Helpman (1991), which
involves intentional R&D investment by firms. We then derive the long-run optimal inflation rate that should be set by
central banks.
Our model demonstrates that the economic growth rate is maximized when central banks set their target inflation rate
at the negative of a fundamental growth rate that is realized without price stickiness. In the model economy, firms’ output
prices are diverted from their optimal level owing to menu costs. Firms do not fine-tune their nominal prices in response
R
We thank Ricardo Reis (Editor), two anonymous referees, Ippei Fujiwara, Tatsuro Iwaisako, Minoru Kitahara, and participants in seminars and con-
ferences at CEF, Hitotsubashi, Keio, Kyoto, Osaka, Tokyo, and Waseda universities. All remaining errors are our own. This work was supported by JSPS
Grant-in-Aid for Scientific Research (C), 17K03635.
∗
Corresponding author.
E-mail addresses: k.oikawa@waseda.jp (K. Oikawa), kozo.ueda@waseda.jp (K. Ueda).
1
The Bank of England Act sets its “objectives for growth and employment.” The Bank of Japan Act and the Treaty on European Union aim for “sound
development of the national economy” and “sustainable development of Europe based on balanced economic growth and price stability,” respectively. In
addition, the Federal Reserve Board considers sustained economic growth as one of its main purposes, although this is not stated in its founding legislation
(Federal Reserve System, 2005).
https://doi.org/10.1016/j.jmoneco.2018.07.012
0304-3932/© 2018 Elsevier B.V. All rights reserved.
Please cite this article as: K. Oikawa, K. Ueda, The optimal inflation rate under Schumpeterian growth, Journal of Monetary
Economics (2018), https://doi.org/10.1016/j.jmoneco.2018.07.012
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2 K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12
to developments in nominal wages. Consequently, both inflation and deflation suppress the real profit flows the potential
entrants would obtain after innovation, thus decreasing innovation incentives and lowering the real economic growth rate.
When the inflation rate equals the negative of a fundamental growth rate, the nominal growth rate becomes zero and
nominal rigidity is virtually eliminated, and the rates of both creative destruction and economic growth are maximized.
However, the optimal inflation rate may deviate from the negative of the fundamental real growth rate for the following
two reasons. The first is the possibility of overinvestment due to negative externality via the business-stealing effect, as in
Aghion and Howitt (1992). In this case, central banks should discourage the R&D investment of firms. The other reason is
the multiple equilibria occurring around the growth-maximizing inflation rate. When central banks set the inflation rate at
the negative of a fundamental growth rate, the equilibrium realized might be such that the nominal growth rate is negative
and the real growth rate is lower than the desired level. If one or both of these mechanisms are significant, an inflation rate
higher than the growth-maximizing rate becomes optimal.
The model calibrated to the US economy shows that the cost of suboptimal inflation is sizable. On the balanced growth
path, the growth rate is reduced by half at about 10% inflation or deflation. This quantitative impact is strikingly large
relative to existing studies; for example, see Jones and Manuelli (1995) and Lucas (20 0 0). The problems of overinvestment
and multiple equilibria have no significant impacts on the optimal inflation rate. This inflation rate is very close to the
growth-maximizing inflation rate, which is around −2%.
While this study focuses on the optimal long-run inflation rate under endogenous growth, another contribution of this
study is its presentation of a new basic and tractable model linking monetary policy to economic growth. Our model is
based on a creative destruction model appropriate to analyze reallocations based on entry and exit. The menu cost model is
a device to generate effects of nominal variables on the real economy. These two key strands of macroeconomics have not
been synthesized so far, as reviewed in detail below. We believe that by combining state-dependent pricing with Schum-
petrian creative destruction, we can widen the scope of this research in the direction of, for example, firm reallocation or
pricing with product substitution.
This study is related to the following three strands of research. The first pertains to the optimal inflation rate in menu
cost models. Burstein and Hellwig (2008) and Coibion et al. (2012) find that the optimal inflation rate is close to zero. While
this finding is consistent with the findings of other new Keynesian models a la Calvo (1983) or Rotemberg (1982) (e.g.,
Benigno and Woodford, 2005; Goodfriend and King, 1997; Khan et al., 2003; Schmitt-Grohé and Uribe, 2010), menu cost
models further reveal that the welfare costs of inflation become quantitatively smaller from endogenous price adjustments.
Compared to these studies, our contribution is in showing that the endogenous determination of the growth rate modifies
the optimal inflation rate from zero by the fundamental growth rate and that the welfare costs of inflation are sizable
because it influences the growth rate.
The second strand of literature explores the welfare costs of inflation using endogenous growth models. Most of the
earlier studies such as Jones and Manuelli (1995), Gomme (1993), Roubini and Sala-i-Martin (1995), Chari et al. (1995),
Dotsey and Sarte (20 0 0), Gahvari (2012), and Chu and Cozzi (2014) assume either a cash-in-advance (CIA) constraint or
money-in-utility function to produce real effects of nominal variables. Among these, Chu and Cozzi (2014) is the study clos-
est to ours in using the quality ladder model. Their model uses a CIA constraint and creative destruction to analyze cases
where the Friedman rule does not hold. Recently, Arato (2009), Funk and Kromen (2010), and Benigno and Fornaro (2016) in-
troduce nominal rigidity into endogenous growth models. However, none of their models is based on menu costs, although
state-dependent pricing is essential to combine with the quality ladder model, because the latter entails Bertrand competi-
tion. If we assume time-dependent pricing, industry-leading firms may be prevented from revising their prices even when
they exceed their rival’s prices and are unable to sell any product. In such cases, firms should revise their prices by any
means.2
Third, the interaction between inflation and number of product varieties is investigated in Wu and Zhang (2001) and
Bilbiie et al. (2014). For example, Bilbiie et al. (2014) develop a sticky price and endogenous product variety model to
examine the optimal inflation rate under love for variety. They derive cases in which the optimal inflation rate diverts
from zero under some utility functions. The product variety model is one of the two seminal endogenous growth models
paired with the quality ladder model. However, in the former model, monetary policy influences not economic growth, but
only the real economic level.
In addition to these papers, several other empirical studies examine inflation and economic growth. The correlation is
mostly negative in these studies, implying that inflation is harmful for economic growth. Such a correlation is significant
only during periods of high inflation crises and becomes insignificant under low inflation (Ahmed and Rogers, 20 0 0; Barro,
1996; Bruno and Easterly, 1998; Bullard and Keating, 1995). Recently, Chu et al. (2015) provide empirical evidence of a
negative correlation between inflation and R&D investment.
The remainder of this paper is structured as follows. Section 2 lays out the basic model. Section 3 discusses the effects of
inflation, and Section 4 examines the optimal inflation rate. Section 5 conducts numerical simulation, while Section 6 dis-
cusses two practical issues regarding alternative inflation measures and product imitation. Section 7 concludes.
2
In Benigno and Fornaro (2016), output prices are perfectly flexible and nominal rigidity comes from predetermined wages. Thus, the optimization
problem of firms’ R&D investment is separated from that of price setting.
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K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12 3
2. Model
2.1. Basic framework
Time is continuous. A representative household consumes and supplies a fixed amount of labor. Firms developing a new
product by R&D investment enter the market, while firms with an old product exit. The central bank conducts a strict
inflation-targeting policy by anchoring the inflation rate at a certain level. No aggregate uncertainty is present, and we
focus on the balanced growth path. The growth rate of aggregate consumption is denoted by g; it equals the growth rate
of real wage and real household income. The growth rate of an aggregate price index considering quality improvement is
denoted by π . This differs from the growth rate of an aggregate price index based on posted observable prices. The growth
rate of nominal variables, such as nominal demand, nominal consumption, and nominal wages, is denoted by n ≡ g + π . For
convenience, we denote the initial values in period t = 0 without time subscripts; for example, X0 ≡ X.
2.1.1. Households
A representative household has the following preferences over all versions of k ∈ {0, 1, , Kt (j)} for each industry
j ∈ [0, 1]:
∞

Ut = e−ρ (t −t ) log Ct dt , (1)
t
1
Kt ( j )
log Ct = log q( j, k )xt ( j, k ) dj, (2)
0 k=0
where ρ represents the subjective discount rate, Ct is the aggregate consumption, and xt (j, k) and q(j, k) denote the con-
sumption and quality of version k in industry j, respectively.3 Quality evolves as q( j, k ) = qk , where q > 1. The household
maximizes Ut under the usual budget constraint with inelastic labor supply. The total labor is L, which is constant over
time. The standard optimization condition implies the discount rate of real income as r = ρ + g.
2.1.2. Firms
R&D and Entry. A team of λ researchers is required to obtain an idea for the quality improvement of a product. The entry
rate is given by η = Ls /λ, where Ls represents the measure of labor employed for R&D investment and to launch new firms.
Let Wt be the nominal wage. A quality update yields the real present discounted value of Vt . Assuming free entry, firms
conduct R&D and enter product markets when Pt Vt ≥ λWt , where Pt represents the aggregate price index embedding quality
improvement.
Normalizing this by aggregate nominal demand, Et , we define the real value of an entrant as vt ≡ Pt Vt /Et . Now, free entry
implies
λWt /Et = λW ≥ v, (3)
on a balanced growth path, where we assume that E = 1.
If the R&D cost parameter, λ, is sufficiently small, firm entries are positive and inequality (3) holds with equality. Oth-
erwise, R&D investment is not profitable and hence there is no firm entry. Since v is a reward for innovation, a higher v
attracts more potential entrants, thus leading to more rapid real growth along with an increase in the real wage.
Producers. Producers in each industry compete in Bertrand fashion. From Eq. (2), the demand for goods is given by xt ( j, k ) =
Et /pt ( j, k ) for k = Kt ( j ) and zero otherwise, because in each industry, the limit-price strategy is available for the leading
1
firm. Then, the aggregate price index Pt can be written as log Pt = 0 log [ pt ( j, Kt ( j ))/q( j, Kt ( j ))]dj.
Firms produce one unit of goods using one unit of labor. The real period profit of the leading firm is
ξt ( j, k ) − W 1 gt
t ( pt ( j, k )) = e for ξt ( j, k ) ≤ qW , (4)
ξt ( j, k ) P
where ξ t (j, k) is the relative price to Et , defined as pt ( j, k )e−nt . Note that the period profit is maximized at ξ ∗ = qW, which
is the limit price to avoid followers’ entry.
2.2. Pricing under menu costs
Firms must pay a menu cost of κ > 0 times Et in order to adjust their posted prices. Menu costs are paid in units of
aggregated consumption goods. The objective function of a firm at entry, taking r, η, and n = 0 as given constants, is
∞

ti+1
κ Eti+1
Vt = t (ξi e−n(t −ti ) )e−(r+η )(t −t ) dt − e−(r+η )(ti+1 −t ) , (5)
ti Pti+1
i=0
3
Every real variable is measured in quality units. The model goes with the alternative setting in which a unique final good is assembled by various
intermediate goods whose productivities are improved by innovations, and real variables are measured in the amount of goods.
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where ti is the timing of price changes with t0 = t. The entry rate, η, influences firm value because it serves as the exit
(creative destruction) rate for existing firms.
Lemma 1states a basic property of the menu cost models, such as Sheshinski and Weiss (1977). Menu costs generate a
unique inertia band of relative prices. A distinct feature of the band is that the upper threshold equals the limit price, ξ ∗ ,
owing to Bertrand competition.
Lemma 1. Optimal pricing follows an Ss-rule such that it leads to a unique pair of a reset relative price and time interval between
/ [e−|n| ξ ∗ , ξ ∗ ]. ξ0 = ξ ∗ for n > 0 and ξ0 = en ξ ∗
price resets, ξ 0 and , respectively, where a firm adjusts its price to ξ 0 if ξ ∈
for n < 0.
The proofs for all the lemmas and propositions are provided in the online appendix. The relative price increases (de-
creases) monotonically without price adjustment if n > ( < )0. Thus, firms choose the upper threshold as the reset relative
price under positive nominal growth and the lower threshold otherwise. Without nominal rigidity, they choose ξ ∗ once and
then no price adjustment is needed.
The frequency of price changes, indicated by the inverse of , crucially matters to firm value. The time-invariant maxi-
mized firm value at entry is
⎧
en
⎨ ρ +1 η 1 − q
+κ for n > 0,
v= (6)
⎩ 1 e−n

ρ +η 1 − q
for n < 0.
The Ss-pricing generates heterogeneity in prices among firms. As regards the elapsed time after previous price resets,
t ∈ [0, ], the stationary distribution of firms has the density of
η
f (ξ (t )) = e−ηt for given n and η. (7)
1 − e −η
Since firms exit at the creative destruction rate of η, the density is decreasing in t . From Eq. (7) and the demand for

goods, we can derive the total demand for production workers, Lx , such that Lx = 0 f (ξ (t ))/ξ (t )dt . For given n = 0 and
η > 0, this becomes
η 1 1 − e−(η−n)
Lx = . (8)
η − n ξ0 1 − e − η
This labor demand in the production sector influences employment in the R&D sector through the labor market clearing
condition L = Lx + Ls .
2.3. Stationary equilibrium
In the current model, the central bank chooses the inflation rate, π , exogenously as a policy variable. A stationary equi-
librium consists of constant endogenous variables n, g, r, v, η, ξ 0 , , W, Ls , and Lx and a stationary distribution f that satisfy
household lifetime utility maximization, producer optimal Ss-pricing, the free-entry condition (3), the labor-market clearing
condition, and the definition of nominal growth n = g + π .
Proposition 1. For any π , a stationary equilibrium exists. If n ≥ 0, the stationary equilibrium is unique, where the equilibrium
entry and real growth rates, ηˆ (n ) and gˆ(n ) = ηˆ (n ) log q, respectively, are decreasing in n.
In the case of positive nominal growth, a stationary equilibrium, or balanced growth path, uniquely exists. In addition, a
high nominal growth rate is associated with a low entry rate and, thus, a low real growth rate in the stationary equilibrium.
The mechanism behind this relationship is discussed in the next section.
3. Inflation and real growth under nominal rigidity
In this section, we discuss how inflation interacts with two factors, price stickiness and firm entry. To begin with, we
consider the model without either of them.
3.1. Special cases: flexible price or no entry
When the menu cost parameter, κ , is zero so that no nominal rigidity exists, firms always set their prices to keep the
relative price at the limit pricing level, ξ ∗ = qW . Now, the value of the entering firm is independent of nominal growth, and
so are firm entry and real growth. Inflation simply pushes up the nominal growth rate. The economy with flexible price
yields the highest real growth and entry rates, such that

1 L ρ
g = ḡ ≡ η̄ log q, η̄ ≡ 1 − − . (9)
q λ q
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This highest real growth rate realizes even with a nominal rigidity (κ > 0) if the economy does not grow nominally,
because the relative prices are constant under n = 0 even without any control over posted prices.
The second special case is no entry; this case has a sufficiently high R&D cost parameter, λ. Since real growth comes
from quality updates in products, this special case results in no endogenous growth. The economy grows only exogenously
and the model becomes a standard new Keynesian model with menu costs.
3.2. The channel from nominal to real growth
We retrieve menu cost and firm entry to demonstrate a new channel from nominal factors to real growth. The key
variable here is an entrant’s value, v, since it depends on nominal growth through the pricing decisions of firms and, at the
same time, is a reward for innovation, which is the engine of real growth. Nominal rigidity and firm entry affect firm value
in different ways. Lemma 2 shows the impact of nominal growth on firm value for a given entry rate.
Lemma 2. For given η > 0, both and v are strictly decreasing (increasing) in n if n > ( < )0.
This lemma suggests that a zero nominal growth achieves the maximum firm value and that firm value decreases as n
deviates from 0. This is because a more rapid change in nominal terms implies that relative prices and real profits decline
faster if the posted prices are kept fixed. Firms need more frequent price tuning (so that decreases), but this increases
the burden of menu cost payments.
Next, we examine the impact of firm entry (innovation) on firm value, given a nominal growth rate. We assume that the
labor requirement for R&D, λ, is sufficiently small.
Lemma 3. Given n, is strictly increasing (decreasing) in η if n > ( < )0, and v is strictly decreasing in η.
In other words, frequent innovations lower firm value. This is because firm entries with innovations bring about cre-
ative destruction for incumbents. The expected duration of their business becomes shorter if the R&D sector is activated.
Moreover, the entry rate interacts in nominal terms through . The impact of η on is asymmetric. For n > 0, a decline in
survival rate implies that firms postpone price resets because they might be forced out from the market by entrants soon
after payment of menu costs. When n < 0, the inertia time interval is shortened by an increase in creative destruction rate.
This is because firms start with the lowest relative price threshold. It is more profitable for firms to have their relative prices
close to the limit-price level from the beginning when more risks threaten to shut down their operations, before they make
sufficient profits. These responses of to the entry rate moderate the aforementioned decrease in v.
As Lemma 2 shows, a nominal growth reduces the value of entering firm when n > 0, which in turn reduces innovation
through the free-entry and labor market conditions. Moreover, as Lemma 3 states, such a decline in innovation influences
the value of entering firm in the opposite direction. Such a complex interaction, absent in the standard New Keynesian or
endogenous growth models, results in the negative relation between nominal growth and innovation shown in Proposition 1.
3.3. The effect of inflation on nominal and real growth
The overall effects described in the previous subsection generate the real growth effect of inflation. Inflation or deflation
is not fully absorbed in nominal growth and dampens real growth. The intuitive mechanism is as follows. Consider two
economies with distinct inflation rates. The economy with higher inflation rate tends to have higher nominal growth rate.
Then, it has a lower firm value through the effect stated in Lemma 2. Such a low firm value implies relatively low real
wages owing to the free-entry condition in the R&D sector, (3), thus stimulating labor demand for final goods production
and leading to less employment in the R&D sector and a lower entry rate. Proposition 2 states the role of inflation in this
economy when n ≥ 0 and the growth-maximizing rate of inflation.
Proposition 2. Suppose that n ≥ 0 holds in the stationary equilibrium. There, n is increasing in π and g is decreasing in π . The
maximum real growth rate, ḡ, is attained when π = −ḡ.
On a balanced growth path for a given inflation rate, the real and nominal growth rates have the relationship π =
n − gˆ(n ). Now, the central bank pins down the pair of growth rates by choosing an inflation rate. As argued in Section 3.1,
the maximum real growth rate can be attained when the central bank sets the inflation rate at π = −ḡ so that zero nominal
growth realizes and firms do not have to adjust their prices.
3.4. Multiple equilibria when n < 0
In this subsection, we examine the case of n < 0. We separate this case from the above analyses because of the com-
plexity. Multiple equilibria arise under sufficiently low inflation rates. The reason for this multiplicity is that when n < 0,
gˆ(n ) is increasing in n and the equilibrium gap n − gˆ(n ) between nominal and real growth is nonmonotonic. Thus, there
exist multiple pairs of n and g that are consistent with a single inflation rate. Since the model economy does not have any
selection mechanism for the multiple equilibria, this property may be a source of fluctuations from one balanced growth
path to another.
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However, in reality, this is not a big problem. Numerical analysis in Section 5 shows that the region in which multiple
equilibria occur is very tiny. Even if the economy fluctuates between the multiple equilibria, the impact is quantitatively
negligible. Another reason for us to consider multiple equilibria insignificant is that a stationary equilibrium is unique in
terms of nominal growth. If the central bank targets a nominal growth rate, instead of the inflation rate, we do not find it
difficult to determine the stationary equilibrium. Once we consider the multiple equilibria problem insignificant, the analysis
under n < 0 is analogous to that under n > 0.
4. The optimal inflation rate
Given the equilibrium relationship π = n − gˆ(n ), the central bank can choose a unique pair of real and nominal growth
rates by choosing π .
4.1. Welfare in competitive equilibrium and the social planner’s problem
On a given balanced growth path, welfare at t = 0 is obtained as

∞
η log q log C
U= e−ρ t log Ct dt = + , (10)
0 ρ2 ρ
where C = [1 − κ f (ξ ( ))]/P from the resource constraint and Pt Ct + κ Et f (ξ ( )) = Et . Note that a high entry rate directly
raises welfare whereas it may indirectly reduce real consumption through a high price level. Real consumption is also re-
duced by menu cost payments.
To obtain the optimal inflation rate, we solve the social planner’s problem without market transactions. The social plan-
ner chooses η to maximize
∞
e−ρ t [Kt log q + log(L − λη )]dt s.t. Kt˙ = η,
0
1
where we define Kt ≡ 0 Kt ( j )dj. The social optimal entry rate is calculated as
η = L/λ − ρ / log q.
∗
(11)
4.2. Underinvestment and overinvestment in R&D
The growth-maximization rate of inflation, π = −ḡ, is not necessarily optimal because overly rapid real growth harms
household welfare. Quality improvement by innovation is log q from the social point of view, whereas private firms look
at q, which is higher than log q, as the source of profits. Thus, a negative externality exists in R&D activity, as pointed out
by Aghion and Howitt (1992). Since, in contrast, R&D generates a positive externality through knowledge spillover, whether
R&D is over- or underinvested depends on the balance of those externalities.
If the maximum entry rate attained in the competitive equilibrium η̄ is no more than the social optimal entry η∗ , R&D
is always underinvested in a competitive equilibrium. From Eqs. (9) and (11), this case occurs if
L
λ≤ . (12)
ρ (q/ log q − 1 )
If the required labor for R&D, λ, is sufficiently small, the competitive equilibrium is underinvested. Now, the optimal inflation
rate is π = −ḡ. Although this does not attain the optimal real growth rate, it is the second-best solution implemented by
controlling the inflation rate. The threshold on λ is decreasing in the size of negative externality, q/log q. Therefore, a greater
quality gap indicates a smaller region of R&D cost, generating underinvestment.
To the contrary, if inequality (12) does not hold, or equivalently, η̄ > η∗ , setting π = −ḡ leads to overinvestment in R&D.
The central bank can reduce R&D investment and thus firm entry by choosing a higher inflation rate. This inflation rate
works as a tax on R&D, because a positive nominal growth imposes menu cost payments and reduces firm value.4 However,
R&D overinvestment is not enough for the optimal inflation rate to divert from the growth-maximizing inflation rate. A de-
viation from π = −ḡ is costly because non-zero nominal growth generates both menu cost payments and different markups
across firms, increasing inefficiency.5 Thus, π = −ḡ is not optimal if the benefit from reducing the inefficiency of overinvest-
ment overwhelms the burden from menu cost payments. Such a situation actually arises when λ is sufficiently large. When
λ is large, even a tiny decrease in entry rate releases a sufficient amount of labor to the production sector. In this case,
the economy can afford to pay menu costs incurred by the non-zero nominal growth required to reduce R&D investment.
Proposition 3 summarizes this.
4
Chu and Cozzi (2014) demonstrate a similar mechanism by which a nonzero nominal interest rate works as R&D tax with the CIA constraint for R&D.
5
This type of inefficiency is absent in standard endogenous growth models, where markups are homogenous across firms. In contrast, it is typical in
the new Keynesian literature without real growth, where zero inflation, corresponding to the inflation rate generating n = 0 in our model, has been found
optimal (Schmitt-Grohé and Uribe, 2010).
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Proposition 3. Suppose n ≥ 0 in the stationary equilibrium. The optimal inflation rate is −ḡ if (12) holds. Otherwise, the optimal
inflation rate is higher than or equal to −ḡ, where strict inequality holds if λ is sufficiently large.
If we drop R&D and firm entry, the current model falls into a standard new Keynesian model. The optimal inflation
rate is zero (π = n = 0), at which the inefficiency from nominal rigidity is eliminated. An endogenous firm entry in the
Shcumpeterian fashion generates two deviations from the standard new Keynesian model. One is that π = −ḡ is required
to get rid of inefficiency from nominal rigidity. The other is that π = −ḡ is not necessarily optimal because of the negative
externality of R&D.
The current analysis also has an implication for optimal R&D subsidies (or tax). They can be incorporated to the model as
shifts in R&D cost parameter λ. Socially optimal real growth is implemented by adjusting λ to make (12) hold with equality
only in case of absence of nominal growth. Therefore, we need an appropriate combination of inflation and targeted R&D
policies to achieve the social optimum under nominal rigidity.
4.3. The optimal inflation rate when n < 0
When we allow n < 0 as a stationary equilibrium, multiple equilibria occur around π = −ḡ. Since the region of π causing
multiple equilibria is restricted for π ∈ [−ḡ, 0 ), the economy can overcome the problem with a sufficiently high inflation or
deflation rate.
As mentioned in Section 3.4, the region of multiple equilibria is small in our calibrated model. The central bank can avoid
the multiple equilibria problem by having an inflation rate slightly higher than −ḡ. Moreover, even with π = −ḡ, only a tiny
gap exists between two balanced growth paths. Therefore, the optimal inflation rate is hardly influenced by this theoretical
problem in reality.
5. Numerical simulation
5.1. Calibration
For expositional purposes, we conduct numerical simulation calibrated to the US economy on an annual basis. We assume
that L = 1 and set ρ = 0.05. During 1977–2012, the average per-capita real GDP growth rate, g, was 0.0162, and, according to
the Longitudinal Business Database, the average entry and exit rate for establishments, η, was 0.118. Because of the difficulty
of obtaining an accurate inflation rate embedding product turnover and quality improvement, we simply assume that the
average inflation rate during the period was zero in the benchmark.6 For the menu cost parameter, we set κ = 0.022, as
calibrated by Midrigan (2011), to match the actual price developments at product and retail-store levels.7 To derive these
numbers as equilibrium in the model, we calibrate λ and q as 0.66 and 1.15, respectively.
5.2. Numerical results
5.2.1. The effects of inflation

Fig. 1 shows how the equilibrium changes depending on inflation rates, π . The top left-hand and right-hand side panels
indicate the real growth rate g and welfare, respectively. Welfare is expressed in the unit of consumption. For example,
−0.1 means that a decrease in welfare amounts to a permanent decrease in level of log consumption by 0.1, compared with
the welfare-maximizing equilibrium. The bottom left-hand side panel shows the entry and exit rate η and labor employed
to generate R&D investment Ls . The bottom right-hand side panel shows the time interval between two consecutive price
changes . The horizontal axis is the inflation rate π and the vertical line in each panel indicates the benchmark π = 0.
The top left-hand side panel shows that when π = −2.09%, the real growth rate g is maximized at the level of ḡ = 2.09%.
The nominal growth rate n is zero and firms face virtually no nominal rigidity because they do not have to adjust their
output prices; that is, is infinite. Thus, as the top right-hand side panel shows, welfare is maximized at this level.
As π deviates from the optimal level, both g and welfare decrease. Inflation and deflation induce firms to revise their
prices frequently, thus shortening , as shown in the bottom right-hand side panel. This, in turn, increases menu cost
payments and suppresses the real profit flows of potential entrants, thus decreasing innovation incentives and, hence, η and
Ls , as shown in the bottom left-hand side panel. As a result, the real economic growth rate and welfare decrease.
Quantitatively, a deviation from the optimal level has sizable impacts. When π = 0%, g declines from 2.09% to 1.62%
(which is the actual value in the US). Such a decline in the growth rate matters greatly for welfare. The decrease in welfare
amounts to a decrease in consumption by 8% permanently. A 10% diversion from the optimal inflation rate (both inflation
and deflation) reduces the real growth rate by about half.
These quantitative impacts are strikingly large relative to the existing theoretical studies, for example, Jones and
Manuelli (1995) and Lucas (20 0 0). However, this result is comparable to the recent empirical study by Chu et al. (2015).
6
The average CPI and per-capita nominal GDP growth rates were 0.0387 and 0.0495, respectively, during the period.
7
Levy et al. (1997) obtain κ = 0.007 by directly measuring the menu cost size, such as the labor cost of changing posted prices and the physical costs
for printing and delivering price tags. However, their measure naturally misses the implicit costs associated with decision-making and customer relations
(negotiations), preventing flexible price setting.
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Fig. 1. Quantitative impacts of inflation.
Fig. 2. The region in which non-zero nominal growth improves welfare. The circle indicates the benchmark.
They report that a 1% inflation reduces the R&D share of GDP by 0.37% point. In our model, the R&D share of GDP equals
the labor used in R&D investment, Ls , which decreases from 8 to 4% when the inflation rate increases from 0 to 10%, as the
bottom left-hand side panel shows.
5.2.2. Growth-maximizing and welfare-maximizing equilibrium

In the previous section, we argued that the growth-maximizing equilibrium at n = 0 does not necessarily lead to a
welfare-maximizing equilibrium. To investigate this issue further, in Fig. 2, we show under what parameter values n = 0
improves welfare. We focus on two key parameters, quality step q and R&D cost λ, both of which are key to determining
whether the equilibrium reflects underinvestment or overinvestment.
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Fig. 3. The optimal inflation rate and a welfare change from having a 0% inflation rate. The vertical line indicates the benchmark.
The figure illustrates the existence of four regions. The first region lies at the bottom, where n = 0 maximizes welfare.
In this region, equilibrium reflects underinvestment, and thus a growth-maximizing equilibrium at n = 0 serves the best
outcome. Second, when q is low and λ is high, the entry rate η is zero. Irrespective of n, R&D incentives are too low and the
economy does not grow. The third and fourth regions correspond to overinvestment, which appear for a pair of high q and
λ. Overinvestment is not sufficient to make the optimal n∗ deviate from zero, because it imposes menu costs on firms and
increases price distortion. Thus, in the third region, which lies above the first region, the growth-maximizing equilibrium at
n = 0 remains the best. Finally, for a higher λ, the fourth region appears such that n = 0 leads to the welfare-maximizing
equilibrium.
The benchmark pair calibrated to the US data is located in the first region, as displayed in the filled circle. In other
words, the US economy reveals underinvestment. A growth-maximizing equilibrium at n = 0 or π = −2.09% serves the best
outcome.
In the previous section, we pointed out another reason for the optimal inflation rate to divert from the growth-
maximizing rate, that is, multiple equilibria. Fig. 1 shows that this is not quantitatively important. Multiplicity for a given π
does not appear to cause a significant problem under the parameter set used in benchmark simulation because the region
of multiplicity is too narrow to be shown in the figure.
5.2.3. The optimal inflation rate

Fig. 3 shows how the optimal inflation rate depends on two exogenous parameters associated with firm costs: menu costs
κ and entry costs λ. First, as for κ , the thick solid line in the left-hand side panel indicates that the optimal inflation rate
is −2.09% and independent of κ . This is because the growth-maximizing inflation rate equals the negative of a fundamental
growth rate ḡ that would be realized without menu costs. However, a deviation from the optimal inflation rate becomes
increasingly costly as κ increases. The line with circles shows the amount of welfare changes in the unit of consumption
when π increases from the optimal inflation rate to zero. This illustrates that as κ increases, welfare loss is magnified.
As for λ, the right-hand side panel shows that the optimal inflation rate increases with λ. As the entry costs increase,
R&D is discouraged and the fundamental growth rate under flexible prices ḡ declines, thus raising the optimal inflation rate.
For a sufficiently large λ, the economy stops growing and the optimal inflation rate reaches zero. As λ increases, the welfare
loss from having a 0% inflation rate decreases, because a gap between the optimal and zero inflation rates shrinks.
6. Practical issues
6.1. Alternative measures of inflation rates
The inflation rate π we investigated throughout the paper takes account of quality improvement, and thus can be in-
terpreted as an accurate cost-of-living index. The actual consumer price index is intended to capture product turnover and
quality changes, but such an attempt cannot be perfect (see, e.g., Boskin et al., 1996 and Bils, 2009).
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Fig. 4. Model with imitations.
Now, we consider two alternative measures of inflation rate. The first measure is based on a matched sample: price
changes are calculated only in the case products are not changed. This is written as
π matched = f (ξ ( )) · log(ξ (0 )/ξ ( )) for n = 0.
The second measure considers product turnover, but does not adjust quality improvement. In the case of product re-
placement, price changes are calculated simply by comparing the two prices. This inflation rate is written as
π quality unadjusted = f (ξ ( )) · log(ξ (0 )/ξ ( )) − η · log (P/ξ (0 ) ) for n = 0.
Both inflation rates are 0 if n = 0. Once we use the two alternative measures of inflation rate, the welfare is maximized
when the rates are zero. The bottom right-hand side panel in Fig. 4 for δ = 0 shows the welfare is the highest when the
second measure of inflation rate is zero. In other words, the posted prices should not change to achieve optimality.
6.2. Product imitations
One prediction of our menu cost model is that positive inflation induces firms to always revise their prices upward.
However, Bils (2009) observes from micro price data in the United States that even under a period of positive inflation,
firms tend to lower their prices gradually before they exit the markets. Positive inflation occurs when new products enter
the market with prices higher than those of the replaced ones.
To explain this observation, we extend our model by embedding product imitations by rival firms. A gradual imitation
(catch-up) by rival firms drags down the markups of leading firms.8 A decrease in the optimal markup rates over time would
gradually influence the optimal inflation rate. Furthermore, imitation affects the incentives for R&D and thus changes the
real economic growth rate. Since inflation and growth are interrelated in the abovementioned model, the optimal inflation
rate should depend on whether the leading firms suffer from the rival firms’ imitations.
6.2.1. Extended model

Rival firms gradually imitate the most advanced technology of industry-leading firms. Assume that the second-highest
quality is at qk−1 initially when a new firm enters the market with the newest version of k in a product line. The time
elapsed from the most recent innovation is denoted by τ . Now, through imitations, the second-highest quality increases to
qk as qII (k, τ ) = min(qk−1 eδτ , qk ), where δ is the key exogenous parameter representing the speed of imitation. This suggests
8
For example, after the invention of the iPhone, Apple kept producing its products while gradually lowering prices because of the intensified competition
with Android and other types of mobile phones. However, Apple still earns positive profits.
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that the ratio of the highest quality to the second-highest quality is given by
qk
qI ( τ ) ≡ = max(qe−δτ , 1 ). (13)
qII (k, τ )
Since qI (τ ) reaches 1 in a finite time, industry-leading firms earn positive profits only in a finite duration. At most, this is
τ ∗ = log q/δ. Without menu costs, the optimal price of the industry-leading firm satisfies p∗t (τ ) = qWt e−δτ for τ ≤ τ ∗ . The
optimal price markup over Wt declines over time.
In this extended model, with menu costs, the optimal time interval between s and S, i = ti − ti−1 , is time variant and
dependent on i, where ti represents the time when firms revise their price for i = 1, 2, · · · . This feature makes our model
somewhat complicated, and hence we rely on numerical simulation.
6.2.2. Numerical simulation

In our numerical simulation, we use the same parameter values as earlier, except for one new parameter, δ . Since we
do not find a plausible value for this, for the sake of illustration only, we assume that δ = 0.002. This means that rival
firms catch up with the leading firms by 0.2% yearly, which we believe is a mild parameter. The case without imitations
corresponds to that of δ = 0.
For the impacts of inflation, see Fig. 4. The figure shows that imitation decreases the real growth rate g, the entry rate
η, and welfare. This is because imitations decrease the value of entrant firms and, in turn, the incentive to undertake R&D
investment. Thus, welfare decreases, although imitations lower the markup, which can increase efficiency. In addition, the
figure shows that imitations amplify the impacts of inflation on real growth and welfare.
Welfare is maximized when n = δ > 0. Under this condition, an increase in nominal wages decreases the price markup
of firms with the same speed as does imitations δ , even when firms keep their prices unchanged. Thus, firms can save their
menu costs, thus maximizing both the real growth rate and welfare. Imitations lead to an optimal nominal growth rate that
is no longer zero.
The optimal inflation rate equals −ḡ + δ, where ḡ represents the real growth rate with no price stickiness. Thus, the op-
timal inflation rate rises by about δ (excluding a difference in ḡ) relative to that in a model without imitations. From the
right-hand side panel at the bottom of the figure, the optimal inflation rate measured without adjusting quality improve-
ment is higher than zero, implying that a positive inflation rate is called for even when the price index is based on posted
prices. On the other hand, although we do not show this here to conserve space, the inflation rate based on a matched
sample supports zero inflation.
7. Conclusion
In this study, we investigated the optimal inflation rate when the real economy grows through creative destruction.
We used a menu cost model to generate the link between nominal and real elements. The key linkage between them
is that the value of firms as a reward for innovation is larger when firms do not have to frequently revise their prices.
An option for the optimal inflation rate is the negative of maximum real growth rate, which implies the maximum real
growth after eliminating nominal rigidity. Through qualitative and quantitative analyses, we examined the cases in which the
optimal inflation rate is different from the growth-maximizing rate. Overinvestment in R&D and multiple equilibria suggest
that a slightly higher inflation rate improves welfare, but numerical analyses show that these factors are not quantitatively
significant. The optimal inflation rate eventually equals the growth-maximizing rate.
The current model ignores several factors that could affect the optimal inflation rate; for example, the zero bound of
nominal interest rates, downward rigidity of wages, CIA constraint, and money-in-utility function.
An important direction for future research could be the transitional dynamics between balanced growth paths. Since
firms are heterogeneous owing to menu costs, the economy does not jump to a balanced growth path immediately after
shocks, unlike in standard creative destruction models. Oikawa and Ueda (2015) examine the short-run effects of monetary
policy using the model we developed.
Supplementary material
Supplementary material associated with this article can be found, in the online version, at 10.1016/j.jmoneco.2018.07.012.
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Contents lists available at ScienceDirect

Journal of Monetary Economics

The optimal inﬂation rate under Schumpeterian growthR

2 K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12

K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12 3

2.1. Basic framework

2.2. Pricing under menu costs

4 K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12

2.3. Stationary equilibrium

3. Inﬂation and real growth under nominal rigidity

3.1. Special cases: ﬂexible price or no entry

K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12 5

3.2. The channel from nominal to real growth

3.3. The effect of inﬂation on nominal and real growth

3.4. Multiple equilibria when n < 0

6 K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12

4. The optimal inﬂation rate

4.1. Welfare in competitive equilibrium and the social planner’s problem

On a given balanced growth path, welfare at t = 0 is obtained as

4.2. Underinvestment and overinvestment in R&D

K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12 7

4.3. The optimal inﬂation rate when n < 0

5.2. Numerical results

5.2.1. The effects of inﬂation

8 K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12

Fig. 1. Quantitative impacts of inﬂation.

5.2.2. Growth-maximizing and welfare-maximizing equilibrium

K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12 9

5.2.3. The optimal inﬂation rate

6.1. Alternative measures of inﬂation rates

10 K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12

Fig. 4. Model with imitations.

π matched = f (ξ ( )) · log(ξ (0 )/ξ ( )) for n = 0.

π quality unadjusted = f (ξ ( )) · log(ξ (0 )/ξ ( )) − η · log (P/ξ (0 ) ) for n = 0.

6.2. Product imitations

6.2.1. Extended model

K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12 11

6.2.2. Numerical simulation

12 K. Oikawa, K. Ueda / Journal of Monetary Economics 000 (2018) 1–12

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