Labor market frictions and optimal steady-state inflation

• We explore how nominal wage and search/matching frictions affect optimal inflation.
• Such frictions generate an optimal inflation rate that is significantly positive.
• Specifically, we find a Ramsey optimal inflation rate of 1:16 percent per year.

In central theories of monetary non-neutrality, the Ramsey optimal steady-state inflation rate varies between the negative of the real interest rate and zero. This paper explores how the interaction of nominal wage and search and matching frictions affect the policy prescription. We show that adding the combination of such frictions to the canonical monetary model can generate an optimal inflation rate that is significantly positive. Specifically, for a standard U.S. calibration, we find a Ramsey optimal inflation rate of 1.16 percent per year.