Inflation tolerance ranges in the New Keynesian model

Abstract

A number of central banks in advanced countries use ranges, or bands, around their inflation
target to formulate their monetary policy strategy. The adoption of such ranges has been
proposed by some policymakers in the context of the Fed and the ECB reviews of their
strategies. Using a standard New Keynesian macroeconomic model, we analyze the
consequences of tolerance range policies, characterized by a stronger reaction of the central
bank to inflation when inflation lies outside the range than when it is close to the target, ie
the central value of the band. We show that (i) a tolerance band should not be a zone of
inaction: the lack of reaction within the band endangers macroeconomic stability and leads
to the possibility of multiple equilibria; (ii) the trade-off between the reaction needed outside
the range versus inside seems unfavorable: a very strong reaction, when inflation is far from
the target, is required to compensate a moderately lower reaction within tolerance band; (iii)
these results, obtained within the framework of a stylized model, are robust to many
alterations, in particular allowing for the zero lower bound.

Keywords: Monetary policy; inflation ranges; inflation bands; ZLB; endogenous regime switching

JEL Classification: E31, E52, E58