Heterogeneity, inflation and optimal delegation

In a simple environment with heterogeneous agents, we demonstrate that the central bank delivers a higher inflation rate than when a population is homogeneous. This tendency to choose a higher level of inflation than efficiency dictates is due to the efficiency-vs-equity trade-off that the central bank faces in this heterogeneous economy. Up to a certain level, inflation decreases inequality. Optimal delegation involves appointing a central bank that puts a higher weight on the utility of the high-productivity workers than society does. This effect of delegation that improves the macroeconomic outcome disappears as homogeneity is restored. However, the inflation level under optimal delegation does not reach the efficiency level.

As the Friedman rule is at odds with the practice of central banks, many of whom have adopted inflation targets somewhere between 2% and 3.5%, a literature has emerged to account for this discrepancy. Some authors have succeeded in this regard by adding such frictions as incomplete tax systems, downward rigidity of prices, and the zero lower bound on nominal interest rates. These features induce the optimal policy to deviate from the Friedman rule. However, it is often the case that it is hard to theoretically justify deviations of inflation from near-zero optimal inflation rates. Our work adds a modest contribution to this research. The paper finds that optimal delegation of monetary policy results in a departure from the Friedman rule. Perhaps more importantly, we also find a tendency of monetary authorities to deliver an inflation rate higher than in the case of homogeneous populations. Thus we believe that heterogeneity may be an important modelling device in accounting for the difference between observed inflation rates and the near-zero optimal levels reported in the literature with homogeneous environments.