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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Optimal Inflation Target with Expectations-Driven Liquidity Traps
Philip Coyle
Taisuke Nakata
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.


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Philip Coyle & Taisuke Nakata, Optimal Inflation Target with Expectations-Driven Liquidity Traps, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2019-036, 17 May 2019.
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Keywords: Liquidity Traps ; Optimal Inflation Target ; Sunspot Shock ; Zero Lower Bound
DOI: 10.17016/FEDS.2019.036
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