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Inflation Targeting and Liquidity Traps under Endogenous Credibility

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  • Hommes, C.H.

    (University of Amsterdam)

  • Lustenhouwer, J.

    (University of Amsterdam)

Abstract

We derive policy implications for an inflation targeting central bank, who’s credibility is endogenous and depends on its past ability to achieve its targets. We do this in a New Keynesian framework with heterogeneous agents and boundedly rational expectations. Our assumptions about expectation formations are more in line with expectations observed in survey data and laboratory experiments than the fairly restrictive rational expectations hypothesis. We find that the region of allowed policy parameters is strictly larger under heterogeneous expectations than under rational expectations. Furthermore, with theoretically optimal monetary policy, global stability of the fundamental steady state can be achieved, implying that the system always converges to the targets of the central bank. This result however no longer holds when the zero lower bound (ZLB) on the nominal interest rate is accounted for. Self-fulfilling deflationary spirals can then occur, even under optimal policy. The occurrence of these liquidity traps crucially depends on the credibility of the central bank. Deflationary spirals can be prevented with a high inflation target, aggressive monetary easing, or a more aggressive response to inflation.

Suggested Citation

  • Hommes, C.H. & Lustenhouwer, J., 2015. "Inflation Targeting and Liquidity Traps under Endogenous Credibility," CeNDEF Working Papers 15-03, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  • Handle: RePEc:ams:ndfwpp:15-03
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    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • C62 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Existence and Stability Conditions of Equilibrium

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