Optimal Inflation Target with Expectations-Driven Liquidity Traps

31 Pages Posted: 25 Jul 2019 Last revised: 21 Oct 2019

See all articles by Taisuke Nakata

Taisuke Nakata

Board of Governors of the Federal Reserve System

Philip Coyle

Board of Governors of the Federal Reserve System

Date Written: 2019-05-17

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 Shock, Zero Lower Bound

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

Suggested Citation

Nakata, Taisuke and Coyle, Philip, Optimal Inflation Target with Expectations-Driven Liquidity Traps (2019-05-17). FEDS Working Paper No. 2019-036. Available at SSRN: https://ssrn.com/abstract=3423244 or http://dx.doi.org/10.17016/FEDS.2019.036

Taisuke Nakata (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Philip Coyle

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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