Average Inflation Targeting and the Interest Rate Lower Bound

Assigning a discretionary central bank a mandate to stabilize an average inflation rate—rather than a period-by-period inflation rate—increases welfare in a New Keynesian model with an occasionally binding lower bound on nominal interest rates. Under rational expectations, the welfare-maximizing averaging window is infinitely long, which means that optimal average inflation targeting (AIT) is equivalent to price level targeting (PLT). However, AIT with a finite, but sufficiently long, averaging window can attain most of the welfare gain from PLT. Under boundedly-rational expectations, if cognitive limitations are sufficiently strong, the optimal averaging window is finite, and the welfare gain of adopting AIT can be small.

Keywords: deflationary bias, expectations, liquidity trap, makeup strategies, monetary policy objectives

JEL Classification: E31, E52, E58, E61, E71

Suggested Citation: Suggested Citation

Nakata, Taisuke and Schmidt, Sebastian and Budianto, Flora, Average Inflation Targeting and the Interest Rate Lower Bound (April, 2020). ECB Working Paper No. 2394, Available at SSRN: https://ssrn.com/abstract=3578543 or http://dx.doi.org/10.2139/ssrn.3578543