February 2013

Welfare Costs of Shifting Trend Inflation

Taisuke Nakata


This paper studies the welfare consequences of exogenous variations in trend inflation in a New Keynesian economy. Consumption and leisure respond asymmetrically to a rise and a decline in trend inflation. As a result, an increase in the variance of shocks to the trend inflation process decreases welfare not only by increasing the volatilities of consumption and leisure, but also by decreasing their average levels. I find that the welfare cost of drifting trend inflation is modest and that it comes mainly from reduced average levels of consumption and leisure, not from their increased volatilities.

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Keywords: Great inflation, second-order approximation, trend inflation, welfare

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Last Update: June 26, 2020