Finance and Economics Discussion Series (FEDS)

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May 2019

Optimal Inflation Target with Expectations-Driven Liquidity Traps

Philip Coyle and Taisuke Nakata

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.
Accessible materials (.zip)

Keywords: Liquidity Traps, Optimal Inflation Target, Sunspot Shock, Zero Lower Bound

DOI: https://doi.org/10.17016/FEDS.2019.036

PDF: Full Paper

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Last Update: January 09, 2020