The Optimal Inflation Target and the Natural Rate of Interest

63 Pages Posted: 20 Feb 2018

See all articles by Philippe Andrade

Philippe Andrade

Federal Reserve Banks - Federal Reserve Bank of Boston

Jordi Galí

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI); Massachusetts Institute of Technology (MIT) - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Hervé le Bihan

Banque de France - Centre de Recherche

Julien Matheron

Banque de France

Multiple version iconThere are 3 versions of this paper

Date Written: February 2018

Abstract

We study how changes in the value of the steady-state real interest rate affect the optimal inflation target, both in the U.S. and the euro area, using an estimated New Keynesian DSGE model that incorporates the zero (or effective) lower bound on the nominal interest rate. We find that this relation is downward sloping, but its slope is not necessarily one-for-one: increases in the optimal inflation rate are generally lower than declines in the steady-state real interest rate. Our approach allows us not only to assess the uncertainty surrounding the optimal inflation target, but also to determine the latter while taking into account the parameter uncertainty facing the policy maker, including uncertainty with regard to the determinants of the steady-state real interest rate. We find that in the currently empirically relevant region for the US as well as the euro area, the slope of the curve is close to -0.9. That finding is robust to allowing for parameter uncertainty.

Keywords: effective lower bound, inflation target

JEL Classification: E31, E52, E58

Suggested Citation

Andrade, Philippe and Gali, Jordi and Le Bihan, Herve and Matheron, Julien, The Optimal Inflation Target and the Natural Rate of Interest (February 2018). CEPR Discussion Paper No. DP12723. Available at SSRN: https://ssrn.com/abstract=3126237

Philippe Andrade (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
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Jordi Gali

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI) ( email )

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain
+34 93 542 2754 (Phone)
+34 93 542 1746 (Fax)

HOME PAGE: http://www.econ.upf.es/~gali

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

50 Memorial Drive
Cambridge, MA 02142
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Herve Le Bihan

Banque de France - Centre de Recherche ( email )

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Room 41-1391
75049 Paris Cedex 01
France

Julien Matheron

Banque de France ( email )

Paris
France

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