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Optimal Inflation Target with Expectations-Driven Liquidity Traps

Philip Coyle and Taisuke Nakata

No 2019-036, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (US)

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.

Keywords: Liquidity Traps; Optimal Inflation Target; Sunspot Shock; Zero Lower Bound (search for similar items in EconPapers)
JEL-codes: E52 E63 E32 E62 E61 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Date: 2019-05-17
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DOI: 10.17016/FEDS.2019.036

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