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dc.contributor.authorLe Bihan, Herve
dc.contributor.authorGali, Jordi
dc.contributor.authorAndrade, Philippe
dc.contributor.authorMatheron, Julien
dc.identifier.citationLe 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).

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.

dc.publisherBrookings Institution Press
dc.subjectInflation target, Effective lower bound, Natural Interest Rate, Steady-State Real Interest Rate
dc.titleThe optimal inflation target and the natural rate of interest
dc.typeJournal Article
dcterms.source.volumeFall 2019 Edition
dcterms.source.numberFall 2019 Edition
dcterms.source.titleBrookings Papers on Economic Activity
curtin.departmentSchool of Economics, Finance and Property
curtin.accessStatusOpen access
curtin.facultyFaculty of Business and Law
curtin.contributor.orcidLe Bihan, Herve [0000-0003-0561-6042]
curtin.contributor.scopusauthoridLe Bihan, Herve [6602391217]

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