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Average inflation targeting and the interest rate lower bound

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  • Budianto, Flora
  • Nakata, Taisuke
  • Schmidt, Sebastian

Abstract

Under conventional inflation targeting (IT), the lower bound on nominal interest rates gives rise to a systematic downward bias in inflation that substantially reduces welfare. Using two variants of a New Keynesian model, we investigate whether a monetary policy strategy that aims to stabilize an average inflation rate—rather than a period-by-period inflation rate—leads to better outcomes. With rational expectations, price level targeting (PLT)—the limiting case of average inflation targeting (AIT)—is optimal, yet AIT with sufficient history dependence reaps most of the benefits of PLT. With boundedly rational expectations, PLT is no longer optimal unless the degree of bounded rationality is small. When deviations from rational expectations are sufficiently large, outcomes can be worse under PLT or AIT with strong history dependence than under IT. Finally, for both variants of the model, inflation conservatism improves welfare by eliminating the deflationary bias without invoking history dependence.

Suggested Citation

  • Budianto, Flora & Nakata, Taisuke & Schmidt, Sebastian, 2023. "Average inflation targeting and the interest rate lower bound," European Economic Review, Elsevier, vol. 152(C).
  • Handle: RePEc:eee:eecrev:v:152:y:2023:i:c:s0014292123000132
    DOI: 10.1016/j.euroecorev.2023.104384
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    More about this item

    Keywords

    Monetary policy objectives; Makeup strategies; Liquidity trap; Deflationary bias;
    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
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy

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