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Inflation Target as a Buffer against Liquidity Trap

Shin-Ichi Nishiyama

No 568, Econometric Society 2004 Far Eastern Meetings from Econometric Society

Abstract: In times of low-inflation, conventional monetary policy is perpetually exposed to the risk of being caught by the liquidity trap. As a part of a pre-emptive monetary policy to avoid the liquidity trap, many economists have pointed out that this risk can be possibly circumvented by targeting a small but positive inflation rate - i.e., so-called the ‘buffer’ role of an inflation target. In this paper, based on the stylized framework of a central bank's linear-quadratic dynamic optimization problem taking into account the zero lower-bound constraint on the nominal interest rate, we analyze the role of an inflation target in reducing the long run stabilization cost stemming from the liquidity trap. We prove the existence of the‘buffer’ role of small but positive inflation in the presence of a liquidity trap. Moreover, we analytically show that a central bank's loss function evaluated at the steady state is decreasing and convex function of an inflation target. Finally, these analytical properties of an inflation target are verified by a numerical method. Sensitivity analyses suggest that, in the presence of a liquidity trap, a central bank faced with volatile macroeconomic shocks should consider the ‘buffer’ role of an

Keywords: deflation; inflation target; liquidity trap; zero-bound (search for similar items in EconPapers)
JEL-codes: C63 E52 E58 (search for similar items in EconPapers)
Date: 2004-08-11
New Economics Papers: this item is included in nep-mon
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