Average Inflation Targeting and the Interest Rate Lower Bound

24 Pages Posted: 3 Mar 2020

See all articles by Flora Budianto

Flora Budianto

Bank for International Settlements (BIS)

Taisuke Nakata

Board of Governors of the Federal Reserve System

Sebastian Schmidt

European Central Bank (ECB)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2020

Abstract

A discretionary central bank with a mandate to stabilize an average inflation rate---rather than period-by-period inflation---increases welfare of a sticky-price economy in which nominal interest rates are occasionally constrained by a lower bound. The welfare gain is driven by two monetary policy motives that arise in the presence of an average inflation objective: the history-dependence motive makes expected future inflation an increasing function of current inflation shortfalls, and vice versa, acting as an automatic stabilizer; and the lower bound risk motive induces the central bank to raise inflation when the risk of hitting the lower bound constraint increases. Under rational expectations, the optimal averaging window is infinitely long, so that the optimal average inflation targeting framework is tantamount to price level targeting. Most of the welfare improvement can, however, be attained by a framework with a finite, but sufficiently long, averaging window. Under boundedly-rational expectations, if cognitive limitations are sufficiently strong, the optimal averaging window is finite, and the welfare gain of adopting an average inflation target can be small.

Keywords: Average Inflation Targeting, Deflationary Bias, liquidity trap, Makeup Strategies, Monetary Policy Objectives

JEL Classification: E31, E52, E58, E61

Suggested Citation

Budianto, Flora and Nakata, Taisuke and Schmidt, Sebastian, Average Inflation Targeting and the Interest Rate Lower Bound (February 2020). CEPR Discussion Paper No. DP14400, Available at SSRN: https://ssrn.com/abstract=3547331

Flora Budianto (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Taisuke Nakata

Board of Governors of the Federal Reserve System ( email )

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

Sebastian Schmidt

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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