There are three reasons for targeting for an inflation rate above zero. The first is measurement bias. Try as they might, most countries do have some bias in their price indexes. It is hard for governmental statistical agencies to eliminate the measurement bias that occurs whenever new and improved goods are introduced to consumers, and new and improved goods are continually being introduced.
It is also hard to deal with substitution bias by updating the weights on various consumer goods. Measurement bias is not huge around the world, and it is coming down as statistical agencies adopt new and improved statistical procedures. But there may still be some irreducible upward bias in measuring inflation.
The second reason for shooting at a rate of inflation slightly above zero is known as the zero bound problem. If a country's real interest rates are close to zero and its inflation rate is close to zero, its nominal interest rates will also be close to zero. Since costs of holding cash are minimal, a central bank cannot push nominal interest rates much below zero.
This means that countries that target for zero inflation could get in the bind of being unable to ease monetary policy in response to recessionary shocks. Today this issue is not much of a problem around most of the world, but it has become a significant problem in Japan. The balance of economic thought on the issue is that, once a country gets into this zero bound situation, it has a very difficult time getting out. This forms a strong rationale for avoiding the danger in the first place, which can be helped by targeting for a low positive rate of inflation (King, 1999).
The third reason for targeting a low positive rate of inflation is labor market inefficiencies. Akerlof.......
