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Inflation Targeting and Liquidity Traps Under Endogenous Credibility

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  • Cars Hommes
  • Joep Lustenhouwer

Abstract

Policy implications are derived for an inflation-targeting central bank, whose credibility is endogenous and depends on its past ability to achieve its targets. This is done in a New Keynesian framework with heterogeneous and boundedly rational expectations. We find that the region of allowed policy parameters is strictly larger than under rational expectations. However, when the zero lower bound on the nominal interest rate is accounted for, self-fulfilling deflationary spirals can occur, depending on the credibility of the central bank. Deflationary spirals can be prevented with a high inflation target and aggressive monetary easing.

Suggested Citation

  • Cars Hommes & Joep Lustenhouwer, 2019. "Inflation Targeting and Liquidity Traps Under Endogenous Credibility," Staff Working Papers 19-9, Bank of Canada.
  • Handle: RePEc:bca:bocawp:19-9
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Hommes, Cars & Lustenhouwer, Joep, 2019. "Managing unanchored, heterogeneous expectations and liquidity traps," Journal of Economic Dynamics and Control, Elsevier, vol. 101(C), pages 1-16.
    2. Bolt, Wilko & Demertzis, Maria & Diks, Cees & Hommes, Cars & Leij, Marco van der, 2019. "Identifying booms and busts in house prices under heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 103(C), pages 234-259.
    3. Hommes, Cars, 2018. "Behavioral & experimental macroeconomics and policy analysis: a complex systems approach," Working Paper Series 2201, European Central Bank.
    4. Gibbs, Christopher G. & Kulish, Mariano, 2017. "Disinflations in a model of imperfectly anchored expectations," European Economic Review, Elsevier, vol. 100(C), pages 157-174.
    5. Gasteiger, Emanuel, 2018. "Do Heterogeneous Expectations Constitute A Challenge For Policy Interaction?," Macroeconomic Dynamics, Cambridge University Press, vol. 22(8), pages 2107-2140, December.
    6. Hagenhoff, Tim & Lustenhouwer, Joep, 2019. "The Rationality Bias," BERG Working Paper Series 144, Bamberg University, Bamberg Economic Research Group.
    7. Kwangyong Park, 2018. "Central Bank Credibility and Monetary Policy," Working Papers 2018-45, Economic Research Institute, Bank of Korea.
    8. Lustenhouwer, Joep & Hagenhoff, Tim, 2019. "The Rationality Bias," Annual Conference 2019 (Leipzig): 30 Years after the Fall of the Berlin Wall - Democracy and Market Economy 203553, Verein für Socialpolitik / German Economic Association.
    9. Gavin Goy & Cars Homme & Kostas Mavromatis, 2018. "Forward Guidance and the Role of Central Bank Credibility," DNB Working Papers 614, Netherlands Central Bank, Research Department.
    10. Hagenhoff, Tim, 2018. "An aggregate welfare optimizing interest rate rule under heterogeneous expectations," BERG Working Paper Series 139, Bamberg University, Bamberg Economic Research Group.

    More about this item

    Keywords

    Business fluctuations and cycles; Credibility; Monetary policy;

    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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