Raising the Inflation Target: How Much Extra Room Does It Really Give?
55 Pages Posted: 19 Jun 2020
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Raising the Inflation Target: How Much Extra Room Does It Really Give?
Raising the Inflation Target: How Much Extra Room Does it Really Give?
Date Written: June 16, 2020
Abstract
Some, but less than intended. The reason is a shift in the behavior of the private sector: Prices adjust more frequently, lowering the potency of monetary policy. We quantitatively investigate this channel across different models, based on a calibration using micro data. By raising the target from 2 percent to 4 percent, the monetary authority gets only between 0.51 and 1.60 percentage points of effective extra policy room for monetary policy (not 2 percentage points as intended). Getting 2 percentage points of effective extra room requires raising the target to more than 4 percent. Taking this channel into consideration raises the optimal inflation target by roughly 1 percentage points relative to earlier computations.
Keywords: timidity trap, zero lower bound, liquidity traps, central bank design, inflation targeting, Lucas proof, price stability
JEL Classification: E31, E52, E58
Suggested Citation: Suggested Citation