The Optimal Inflation Target and the Natural Rate of Interest

Julien Matheron, Philippe Andrade, Hervé Le Bihan and Jordi Galí
Authors registered in the RePEc Author Service: Jordi Galí

No 1009, Working Papers from Barcelona School of Economics

Abstract: We study how changes in the steady-state real interest rate affect the optimal inflation target in a New Keynesian DSGE model with trend inflation and a lower bound on the nominal interest rate. In this setup, a drop in the steady-state real interest rate increases the probability of hitting that constraint. This higher probability can be offset by an increase in the inflation target inducing a higher average nominal interest rate. However, a higher inflation target also entails greater distortion costs induced by steady-state inflation. We estimate the model on both U.S. and euro area data to quantify this trade-off. We find that the relation between the steady-state real interest rate and the optimal inflation target is downward sloping, but its slope is not necessarily one-for-one: increases in the optimal inflation rate are generally lower than declines in the steady-state real interest rate. However, in the currently empirically relevant region for the US as well as the euro area, the slope of the relation is close to -0.9. That latter finding is robust to considering several alternative parameter values as well as parameter uncertainty.

Keywords: macroeconomia; economia internacional (search for similar items in EconPapers)
JEL-codes: E31 E52 E58 (search for similar items in EconPapers)
Date: 2017-12
New Economics Papers: this item is included in nep-cba, nep-dge, nep-eec, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Related works:
Journal Article: The Optimal Inflation Target and the Natural Rate of Interest (2019)
Working Paper: The Optimal Inflation Target and the Natural Rate of Interest (2019)
Working Paper: The optimal inflation target and the natural rate of interest (2019)
Working Paper: The Optimal Inflation Target and the Natural Rate of Interest (2018)
Working Paper: The Optimal Inflation Target and the Natural Rate of Interest (2018)
Working Paper: The Optimal Inflation Target and the Natural Rate of Interest (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:bge:wpaper:1009

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