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Optimal Inflation Target with Expectations-Driven Liquidity Traps

Philip Coyle and Taisuke Nakata
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Philip Coyle: University of Wisconsin – Madison
Taisuke Nakata: University of Tokyo

No CARF-F-485, CARF F-Series from Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo

Abstract: In expectations-driven liquidity traps, a higher inflation target is associated with lower inflation and consumption. As a result, introducing the possibility of expectations-driven liquidity traps to an otherwise standard model lowers the optimal inflation target. Using a calibrated New Keynesian model with an effective lower bound (ELB) constraint on nominal interest rates, we find that even a very small probability of falling into an expectations-driven liquidity trap lowers the optimal inflation target nontrivially. Our analysis provides a reason to be cautious about the argument that central banks should raise their inflation targets in light of a higher likelihood of hitting the ELB.

Pages: 37
Date: 2020-04
New Economics Papers: this item is included in nep-dge, nep-mac and nep-mon
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