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The Inflation Target and the Equilibrium Real Rate

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  • Christopher D. Cotton

Abstract

Many economists have proposed raising the inflation target to reduce the probability of hitting the zero lower bound (ZLB). It is both a common assumption and a feature of standard models that raising the inflation target does not impact the equilibrium real rate. I demonstrate that in the New Keynesian model, once heterogeneity is introduced, raising the inflation target causes the equilibrium real rate to fall. This implies that raising the inflation target will increase the nominal interest rate by less than expected and thus will be less effective in reducing the probability of hitting the ZLB. The channel involves a rise in the inflation target lowering the average markup by price rigidities and a fall in the average markup lowering the equilibrium real rate by household heterogeneity, which could come from overlapping generations or idiosyncratic labor shocks. I find that raising the inflation target from 2 percent to 4 percent lowers the equilibrium real rate between 3 and 28 basis points. Since raising inflation lowers the equilibrium real rate, it might seem optimal to raise inflation by more in response to the ZLB. However, this channel also implies that the marginal benefit of raising inflation is lower because a given increase in inflation raises the nominal interest rate by less and thus is less effective at preventing the ZLB. In a welfare simulation, these two effects approximately cancel out each other. Therefore, even though this channel implies that raising the inflation target is less effective in preventing the ZLB, the inflation target should still be raised by a similar amount in response to the problem of the ZLB.

Suggested Citation

  • Christopher D. Cotton, 2020. "The Inflation Target and the Equilibrium Real Rate," Working Papers 20-2, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbwp:87926
    DOI: 10.29412/res.wp.2020.02
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    Cited by:

    1. Philippe Andrade & Jordi Gali & Hervé Le Bihan & Julien Matheron, 2021. "Should the ECB Adjust Its Strategy in the Face of a Lower r*?," Working Papers 22-1, Federal Reserve Bank of Boston.
    2. Antoine Lepetit, 2022. "The Optimal Inflation Rate with Discount Factor Heterogeneity," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 54(7), pages 1971-1996, October.
    3. Andrade, Philippe & Galí, Jordi & Le Bihan, Hervé & Matheron, Julien, 2021. "Should the ECB adjust its strategy in the face of a lower r★?," Journal of Economic Dynamics and Control, Elsevier, vol. 132(C).

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    More about this item

    Keywords

    inflation target; steady state real interest rate; equilibrium real rate; heterogeneity; zero lower bound;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • 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

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