Price Dispersion and Optimal Inflation: the Spanish Case

Abstract

This paper studies the relation between inflation and relative price variability (RPV) in Spain during the 1987-2009 period. We find that this relation presents a U-shape profile, and that the optimal annual inflation rate (defined as the one that minimizes RPV) is around 4%, higher than the 2% inflation target proposed by the European Monetary Union. More importantly, this result does not depend on whether the monetary regime is before or after the euro. Hence, the main policy implication is that disinflation efforts to achieve the 2% inflation target result in welfare losses. The key link between inflation and RPV is unexpected inflation, whose optimal level is around zero. This suggests that monetary policy matters: the welfare costs associated with higher RPV can be minimized with a credible and predictable inflation targeting policy set at the appropriate level.