Inflation targets and the zero lower bound in a behavioural macroeconomic model

Paul De Grauwe and Yuemei Ji ()

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We analyse the relationship between the level of the inflation target and the zero lower bound imposed on the nominal interest rate in the framework of a behavioural New-Keynesian macroeconomic model in which agents, experiencing cognitive limitations, use adaptive learning forecasting rules. The model produces endogenous waves of optimism and pessimism (animal spirits) that lead to non-normal distributions of the output gap. We find that when the inflation target is too close to zero, the economy can get gripped by ‘chronic pessimism’ that leads to a dominance of negative output gaps and recessions, and in turn feeds back on expectations producing long waves of pessimism. Low inflation targets create the risk of persistence of recessions and low growth. In conclusion, our framework suggests that the 2% inflation target, now pursued by many central banks, is too low.

Keywords: animal spirits; monetary policy; inflation target; behavioraleconomics; zero lower bound (search for similar items in EconPapers)
JEL-codes: E31 E32 (search for similar items in EconPapers)
Pages: 38 pages
Date: 2019-04-01
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

Published in Economica, 1, April, 2019, 86(342), pp. 262-299. ISSN: 0013-0427

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http://eprints.lse.ac.uk/80271/ Open access version. (application/pdf)

Related works:
Journal Article: Inflation Targets and the Zero Lower Bound in a Behavioural Macroeconomic Model (2019)
Working Paper: INFLATION TARGETS AND THE ZERO LOWER BOUND IN A BEHAVIORAL MACROECONOMIC MODEL (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:80271

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