The optimal inflation target and the natural rate of interest

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• dc.contributor.author Andrade, Philippe
• dc.contributor.author Galí, Jordi, 1961-
• dc.contributor.author Le Bihan, Hervé
• dc.contributor.author Matheron, Julien
• dc.date.accessioned 2021-03-25T08:38:11Z
• dc.date.available 2021-03-25T08:38:11Z
• dc.date.issued 2019
• dc.description.abstract 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*.
• dc.format.mimetype application/pdf
• dc.identifier.citation Andrade P, Galí J, Le Bihan H, Matheron J. The optimal inflation target and the natural rate of interest. Brookings Pap Econ Act. 2019;Fall:173-255.
• dc.identifier.issn 0007-2303
• dc.identifier.uri http://hdl.handle.net/10230/46934
• dc.language.iso eng
• dc.publisher Brookings Institution Press
• dc.relation.ispartof Brookings Papers on Economic Activity. 2019;Fall:173-255
• dc.rights © Brookings Institution Press. https://www.brookings.edu/bpea-articles/the-optimal-inflation-target-and-the-natural-rate-of-interest/
• dc.rights.accessRights info:eu-repo/semantics/openAccess
• dc.title The optimal inflation target and the natural rate of interest
• dc.type info:eu-repo/semantics/article
• dc.type.version info:eu-repo/semantics/publishedVersion