Average Inflation Targeting and the Interest Rate Lower Bound

Sebastian Schmidt, Flora Budianto and Taisuke Nakata

No 14400, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Under conventional inflation targeting (IT), the lower bound on nominal interest rates gives rise to a systematic downward bias in inflation that substantially reduces welfare. Using two variants of a New Keynesian model, we investigate whether a monetary policy strategy that aims to stabilize an average inflation rate---rather than a period-by-period inflation rate---leads to better outcomes. With rational expectations, price level targeting (PLT)---the limiting case of average inflation targeting (AIT)---is optimal, yet AIT with sufficient history dependence reaps most of the benefits of PLT. With boundedly rational expectations, PLT is no longer optimal unless the degree of bounded rationality is small. When deviations from rational expectations are sufficiently large, outcomes can be worse under PLT or AIT with strong history dependence than under IT. Finally, for both variants of the model, inflation conservatism improves welfare by eliminating the deflationary bias without invoking history dependence.

Keywords: Monetary policy objectives; Makeup strategies; Liquidity trap; Deflationary bias (search for similar items in EconPapers)
JEL-codes: E31 E52 E58 E61 E71 (search for similar items in EconPapers)
Date: 2020-02
New Economics Papers: this item is included in nep-mac and nep-mon
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Citations: View citations in EconPapers (33)

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Related works:
Journal Article: Average inflation targeting and the interest rate lower bound (2023)
Working Paper: Average inflation targeting and the interest rate lower bound (2020)
Working Paper: Average Inflation Targeting and the Interest Rate Lower Bound (2020)
Working Paper: Average inflation targeting and the interest rate lower bound (2020)
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