Working Paper

Raising the Inflation Target: How Much Extra Room Does It Really Give?

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;

https://doi.org/10.26509/frbc-wp-202016

Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers

Publication Date: 2020-06-16

Number: 20-16