Two Percent is a Bargain
Abstract
Most central banks in the developed world have a two percent inflation target, or at least a target range that includes two percent. It is unclear why this is the case. A two percent inflation rate is below the typical seigniorage-maximizing rate, but it is above most estimates of optimal inflation found in the literature. In this paper, I argue that the two percent inflation target is the result of a political bargain. In particular, I appeal to a price theoretic interpretation of the core, applied to a monopoly supplier. I show that there are gains from trade to both households and a seigniorage-maximizing central bank when there is a commitment to an inflation target below the otherwise seignioragemaximizing rate. These gains from trade can only be obtained through a political bargain. I argue that both the institutional characteristics of inflation targeting central banks and the response of money demand to unexpected inflation are consistent with my theory. I also show that variation in inflation targets across countries are explained by political accountability and not state capacity, which is again consistent with my theory.
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