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The optimal inflation target and the natural rate of interest

Philippe Andrade (), Jordi Galí (), Hervé Le Bihan () and Julien Matheron ()

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: We study how changes in the steady-state real interest rate affect the optimal inflation target in a New Keynesian DSGE model with trend inflation and a lower bound on the nominal interest rate. In this setup, a drop in the steady-state real interest rate increases the probability of hitting that constraint.This higher probability can be offset by an increase in the inflation target inducing a higher average nominal interest rate. However, a higher inflation target also entails greater distortion costs induced by steady-state inflation. We estimate the model on both U.S. and euro area data to quantify this trade-off. We find that the relation between the steady-state real interest rate and the optimal inflation target is downward sloping, but its slope is not necessarily one-for-one: increases in the optimal inflation rate are generally lower than declines in the steady-state real interest rate. However, in the currently empirically relevant region for the US as well as the euro area, the slope of the relation is close to -0.9. That latter finding is robust to considering several alternative parameter values as well as parameter uncertainty

Keywords: inflation target; effective lower bound. (search for similar items in EconPapers)
JEL-codes: E31 E52 E58 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Date: 2017-12, Revised 2019-02
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Related works:
Working Paper: The Optimal Inflation Target and the Natural Rate of Interest (2018) Downloads
Working Paper: The Optimal Inflation Target and the Natural Rate of Interest (2018) Downloads
Working Paper: The Optimal Inflation Target and the Natural Rate of Interest (2018) Downloads
Working Paper: The Optimal Inflation Target and the Natural Rate of Interest (2017) Downloads
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