We study how changes in the steady-state real interest rate
(henceforth r*) affect the optimal inflation target in a New Keynesian dynamic
stochastic general equilibrium (DSGE) model with trend inflation and a lower
bound on the nominal interest rate. In this setup, a lower r* increases the probability
of hitting the lower bound. That effect can be counteracted by an increase
in the inflation target, but the resulting higher steady-state inflation has a
welfare cost in and of itself. We use ...
We study how changes in the steady-state real interest rate
(henceforth r*) affect the optimal inflation target in a New Keynesian dynamic
stochastic general equilibrium (DSGE) model with trend inflation and a lower
bound on the nominal interest rate. In this setup, a lower r* increases the probability
of hitting the lower bound. That effect can be counteracted by an increase
in the inflation target, but the resulting higher steady-state inflation has a
welfare cost in and of itself. We use an estimated DSGE model to quantify that
trade-off and determine the implied optimal inflation target, conditional on the
monetary policy rule in place before the financial crisis. The relation between
r* and the optimal inflation target is downward sloping. While the increase in
the optimal inflation rate is in general smaller than the decline in r*, in the
currently empirically relevant region the slope of the relation is found to be
close to −1. That slope is robust to allowing for parameter uncertainty. Under makeup strategies such as price level targeting, the optimal inflation target is
significantly lower and less sensitive to r*.
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