Andrade, PhilippeGalí, Jordi, 1961-Le Bihan, HervéMatheron, Julien2021-03-252021-03-252019Andrade P, Galí J, Le Bihan H, Matheron J. The optimal inflation target and the natural rate of interest. Brookings Pap Econ Act. 2019;Fall:173-255.0007-2303http://hdl.handle.net/10230/46934We 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*.application/pdfeng© Brookings Institution Press. https://www.brookings.edu/bpea-articles/the-optimal-inflation-target-and-the-natural-rate-of-interest/info:eu-repo/semantics/articleinfo:eu-repo/semantics/openAccess