International Finance Discussion Papers: Optimal Inflation Persistence: Ramsey Taxation with Capital and Habits

Ramsey models of fiscal and monetary policy with perfectly-competitive product markets and a fixed supply of capital predict highly volatile inflation with no serial correlation. In this paper, we show that an otherwise-standard Ramsey model that incorporates capital accumulation and habit persistence predicts highly persistent inflation. The result depends on increases in either the ability to smooth consumption or the preference for doing so. The effect operates through the Fisher relationship: a smoother profile of consumption implies a more persistent real interest rate, which in turn implies persistent optimal inflation. Our work complements a recent strand of the Ramsey literature based on models with nominal rigidities. In these models, inflation volatility is lower but continues to exhibit very little persistence. We quantify the effects of habit and capital on inflation persistence and also relate our findings to recent work on optimal fiscal policy with incomplete markets.