Changes in the Inflation Target and the Comovement between Inflation and the Nominal Interest Rate
Yunjong Eo () and
Denny Lie ()
No 2018-02, Working Papers from University of Sydney, School of Economics
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; Taylor-type rule; hybrid NKPC; hybrid IS curve (search for similar items in EconPapers)
Date: 2018-07, Revised 2020-05
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: Track citations by RSS feed
Downloads: (external link)
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)
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
Persistent link: https://EconPapers.repec.org/RePEc:syd:wpaper:2018-02
Access Statistics for this paper
More papers in Working Papers from University of Sydney, School of Economics Contact information at EDIRC.
Bibliographic data for series maintained by Vanessa Holcombe ().