Working Paper

Optimal Inflation Target with Expectations-Driven Liquidity Traps

Abstract: In expectations-driven liquidity traps, a higher inflation target is associated with lower inflation and consumption. As a result, introducing the possibility of expectations-driven liquidity traps to an otherwise standard model lowers the optimal inflation target. Using a calibrated New Keynesian model with an effective lower bound (ELB) constraint on nominal interest rates, we find that even a very small probability of falling into an expectations-driven liquidity trap lowers the optimal inflation target nontrivially. Our analysis provides a reason to be cautious about the argument that central banks should raise their inflation targets in light of a higher likelihood of hitting the ELB.

Keywords: Liquidity Traps; Optimal Inflation Target; sunspot shocks; Zero Lower Bound;

JEL Classification: E52; E63; E32; E62; E61;

https://doi.org/10.17016/FEDS.2019.036

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2019-05-17

Number: 2019-036

Pages: 31 pages