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    The optimal inflation target and the natural rate of interest

    81278.pdf (1.736Mb)
    Access Status
    Open access
    Authors
    Le Bihan, Herve
    Gali, Jordi
    Andrade, Philippe
    Matheron, Julien
    Date
    2019
    Type
    Journal Article
    
    Metadata
    Show full item record
    Citation
    Le Bihan, H. and Gali, J. and Andrade, P. and Matheron, J. 2019. The optimal inflation target and the natural rate of interest. Brookings Papers on Economic Activity. Fall 2019 Edition (Fall 2019 Edition).
    Source Title
    Brookings Papers on Economic Activity
    ISSN
    0007-2303
    Faculty
    Faculty of Business and Law
    School
    School of Economics, Finance and Property
    URI
    http://hdl.handle.net/20.500.11937/81197
    Collection
    • Curtin Research Publications
    Abstract

    We study how changes in the steady-state real interest rate affect the optimal inflation target in a New Keynesian DSGE model with trend inflation and a lower bound on the nominal interest rate. In this setup, a lower steady-state real interest rate increases the probability of hitting the lower bound. That effect can be counteracted by an increase in the inflation target, but the resulting higher steadystate inflation has a welfare cost in and of itself. We use an estimated DSGE model to quantify that trade-off and determine the implied optimal inflation target, conditional on the monetary policy rule in place before the financial crisis. The relation between the steady-state real interest rate and the optimal inflation target is downward sloping. While the increase in the optimal inflation rate is in general smaller than the decline in the steady-state real interest rate, in the currently empirically relevant region the slope of the relation is found to be close to −1. That slope is robust to allowing for parameter uncertainty. Under “make-up” strategies such as price level targeting, the required increase in the optimal inflation target under lower steady-state real interest rate is, however, much smaller.

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