Changes in the Inflation Target and the Comovement between Inflation and the Nominal Interest Rate

Yunjong Eo and Denny Lie

No 2003, Discussion Paper Series from Institute of Economic Research, Korea University

Abstract: Would raising the inflation target require an increase in the nominal interest rate in the short run? We answer this policy question, first analytically in a small-scale New Keynesian model with backward-looking components where a closed-form solution exists, and then in a medium-scale model of Smets and Wouters (2007) calibrated to the U.S. economy. Our analysis shows that the short-run comovement between inflation and the nominal interest rate conditional on changes in the inflation target is more likely to be positive, all else equal, as the monetary authority reacts less aggressively to the deviation of inflation from its target. Meanwhile, features of the model that enhance backward-looking behavior, such as backward price indexation and habit formation in consumption, are shown to reduce the likelihood of the positive comovement. However, our investigations reveal that in both models, this positive comovement or so-called Neo-Fisherism is prevalent across a wide-range of empirically-plausible parameter values. Using the Smets and Wouters model with a zero lower bound constraint (ZLB) on the nominal interest rate, we show that raising the inflation target could be an effective alternative policy framework to reduce the possibility of a binding ZLB constraint and to mitigate the potentially large output loss.

Keywords: Neo-Fisherism; zero lower bound; inflation expectations; Taylortype rule; hybrid NKPC; hybrid IS curve (search for similar items in EconPapers)
JEL-codes: E12 E32 E58 E61 (search for similar items in EconPapers)
Date: 2020
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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Related works:
Journal Article: Changes in the Inflation Target and the Comovement Between Inflation and the Nominal Interest Rate (2025)
Working Paper: Changes in the Inflation Target and the Comovement between Inflation and the Nominal Interest Rate (2020)
Working Paper: Changes in the inflation target and the comovement between inflation and the nominal interest rate (2019)
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