Inflation Targets and the Zero Lower Bound in a Behavioural Macroeconomic Model

38 Pages Posted: 6 Mar 2019

See all articles by Paul De Grauwe

Paul De Grauwe

London School of Economics & Political Science (LSE); CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR)

Yuemei Ji

University College London - School of Slavonic and East European Studies

Date Written: April 2019

Abstract

We analyse the relationship between the level of the inflation target and the zero lower bound imposed on the nominal interest rate in the framework of a behavioural New‐Keynesian macroeconomic model in which agents, experiencing cognitive limitations, use adaptive learning forecasting rules. The model produces endogenous waves of optimism and pessimism (animal spirits) that lead to non‐normal distributions of the output gap. We find that when the inflation target is too close to zero, the economy can get gripped by ‘chronic pessimism’ that leads to a dominance of negative output gaps and recessions, and in turn feeds back on expectations producing long waves of pessimism. Low inflation targets create the risk of persistence of recessions and low growth. In conclusion, our framework suggests that the 2% inflation target, now pursued by many central banks, is too low.

Suggested Citation

De Grauwe, Paul and Ji, Yuemei, Inflation Targets and the Zero Lower Bound in a Behavioural Macroeconomic Model (April 2019). Economica, Vol. 86, Issue 342, pp. 262-299, 2019. Available at SSRN: https://ssrn.com/abstract=3345648 or http://dx.doi.org/10.1111/ecca.12261

Paul De Grauwe (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Yuemei Ji

University College London - School of Slavonic and East European Studies ( email )

Malet Street
London WC1E 7HU
United Kingdom

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