Optimal Inflation Target with Expectations-Driven Liquidity Traps
31 Pages Posted: 25 Jul 2019 Last revised: 21 Oct 2019
Date Written: 2019-05-17
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: Suggested Citation