Inflation Target as a Buffer against Liquidity Trap
AbstractIn times of low-inflation, conventional monetary policy is perpetually exposed to the risk of being caught by the liquidity trap. As a part of a pre-emptive monetary policy to avoid the liquidity trap, many economists have pointed out that this risk can be possibly circumvented by targeting a small but positive inflation rate - i.e., so-called the Ã¢â‚¬ËœbufferÃ¢â‚¬â„¢ role of an inflation target. In this paper, based on the stylized framework of a central bank's linear-quadratic dynamic optimization problem taking into account the zero lower-bound constraint on the nominal interest rate, we analyze the role of an inflation target in reducing the long run stabilization cost stemming from the liquidity trap. We prove the existence of theÃ¢â‚¬ËœbufferÃ¢â‚¬â„¢ role of small but positive inflation in the presence of a liquidity trap. Moreover, we analytically show that a central bank's loss function evaluated at the steady state is decreasing and convex function of an inflation target. Finally, these analytical properties of an inflation target are verified by a numerical method. Sensitivity analyses suggest that, in the presence of a liquidity trap, a central bank faced with volatile macroeconomic shocks should consider the Ã¢â‚¬ËœbufferÃ¢â‚¬â„¢ role of an
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Bibliographic InfoPaper provided by Econometric Society in its series Econometric Society 2004 Far Eastern Meetings with number 568.
Date of creation: 11 Aug 2004
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deflation; inflation target; liquidity trap; zero-bound;
Find related papers by JEL classification:
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
- C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
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- Sanjit Dhami & Ali al-Nowaihi, 2005.
"Alice Through the Looking Glass: Strategic Monetary and Fiscal Policy Interaction in a Liquidity Trap,"
Discussion Papers in Economics
05/17, Department of Economics, University of Leicester, revised Aug 2006.
- Sanjit Dhami & Ali al-Nowaihi, 2007. "Alice Through the Looking Glass: Strategic Monetary and Fiscal Policy Interaction in a Liquidity Trap," Discussion Papers in Economics 07/15, Department of Economics, University of Leicester.
- Ali al-Nowaihi & Sanjit Dhami, 2011. "Strategic monetary and fiscal policy interaction in a liquidity trap," Discussion Papers in Economics 11/43, Department of Economics, University of Leicester.
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