Trend Inflation and the Costs of Price Dispersion in a Fiscal DSGE Model

ABSTRACT Most inflation‐targeting frameworks allow for a positive trend inflation rate, yet its optimal level remains uncertain. The extended deliberation in South Africa to move from a 3%–6% target band to a 3% target (with a 1% tolerance band) illustrates this tension. Using a medium‐scale New Keynesian DSGE model with nominal price rigidities and fiscal dynamics, this paper shows that even moderate trend inflation causes significant resource misallocation through price dispersion, flattens the Phillips curve and raises welfare losses and sacrifice ratios. Omitting trend inflation in a Taylor‐rule framework overstates policy inertia and understates the responsiveness needed to stabilise prices. Anchoring expectations closer to lower bound of the target band improves stability: lowering trend inflation from 6% to 3% reduces the sacrifice ratio by 0.67 percentage points.