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The Optimal Inflation Target and the Natural Rate of Interest

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  • Philippe Andrade
  • Jordi Galí
  • Hervé Le Bihan
  • Julien Matheron

Abstract

We study how changes in the steady-state real interest rate affect the optimal inflation target in a New Keynesian DSGE model with trend inflation and a lower bound on the nominal interest rate. In this setup, a drop in the steady-state real interest rate increases the probability of hitting that constraint. This higher probability can be offset by an increase in the inflation target inducing a higher average nominal interest rate. However, a higher inflation target also entails greater distortion costs induced by steady-state inflation. We estimate the model on both U.S. and euro area data to quantify this trade-off. We find that the relation between the steady-state real interest rate and the optimal inflation target is downward sloping, but its slope is not necessarily one-for-one: increases in the optimal inflation rate are generally lower than declines in the steady-state real interest rate. However, in the currently empirically relevant region for the US as well as the euro area, the slope of the relation is close to -0.9. That latter finding is robust to considering several alternative parameter values as well as parameter uncertainty.

Suggested Citation

  • Philippe Andrade & Jordi Galí & Hervé Le Bihan & Julien Matheron, 2017. "The Optimal Inflation Target and the Natural Rate of Interest," Working Papers 1009, Barcelona Graduate School of Economics.
  • Handle: RePEc:bge:wpaper:1009
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. The Optimal Inflation Target and the Natural Rate of Interest
      by Christian Zimmermann in NEP-DGE blog on 2018-01-13 04:03:39

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    Cited by:

    1. Christian Pfister & Jean-Guillaume Sahuc, 2020. "Unconventional monetary policies: A stock-taking exercise," Revue d'économie politique, Dalloz, vol. 130(2), pages 137-169.
    2. Davide Debortoli & Jordi Galí & Luca Gambetti, 2020. "On the Empirical (Ir)Relevance of the Zero Lower Bound Constraint," NBER Macroeconomics Annual, University of Chicago Press, vol. 34(1), pages 141-170.
    3. Zhang, Ren & Martínez-García, Enrique & Wynne, Mark A. & Grossman, Valerie, 2021. "Ties that bind: Estimating the natural rate of interest for small open economies," Journal of International Money and Finance, Elsevier, vol. 113(C).
    4. Stéphane Dupraz & Emi Nakamura & Jón Steinsson, 2019. "A Plucking Model of Business Cycles," NBER Working Papers 26351, National Bureau of Economic Research, Inc.
    5. Antoine Lepetit, 2017. "The Optimal Inflation Rate with Discount Factor Heterogeneity," Working Papers hal-01527816, HAL.
    6. Günter Coenen & Carlos Montes-Galdón & Frank Smets, 2019. "Effects of State-Dependent Forward Guidance, Large-Scale Asset Purchases and Fiscal Stimulus in a Low-Interest-Rate Environment," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 19/983, Ghent University, Faculty of Economics and Business Administration.
    7. Alfredo García-Hiernaux & María T. González-Pérez & David E. Guerrero, 2020. "Eurozone prices: a tale of convergence and divergence," Working Papers 2010, Banco de España.
    8. Koeda, Junko, 2019. "Macroeconomic effects of quantitative and qualitative monetary easing measures," Journal of the Japanese and International Economies, Elsevier, vol. 52(C), pages 121-141.
    9. Sheremirov, Viacheslav, 2020. "Price dispersion and inflation: New facts and theoretical implications," Journal of Monetary Economics, Elsevier, vol. 114(C), pages 59-70.
    10. Tomohide Mineyama & Wataru Hirata & Kenji Nishizaki, 2019. "Inflation and Social Welfare in a New Keynesian Model: The Case of Japan and the U.S," Bank of Japan Working Paper Series 19-E-10, Bank of Japan.
    11. Lhuillier, Jean-Paul & Schoenle, Raphael, 2019. "Raising the Inflation Target: How Much Extra Room Does It Really Give?," CEPR Discussion Papers 14142, C.E.P.R. Discussion Papers.
    12. Lis, Eliza & Nickel, Christiane & Papetti, Andrea, 2020. "Demographics and inflation in the euro area: a two-sector new Keynesian perspective," Working Paper Series 2382, European Central Bank.
    13. Aliaga Miranda, Augusto, 2020. "Monetary policy rules for an open economy with financial frictions: A Bayesian approach," Dynare Working Papers 62, CEPREMAP.
    14. Brand, Claus & Bielecki, Marcin & Penalver, Adrian, 2018. "The natural rate of interest: estimates, drivers, and challenges to monetary policy JEL Classification: E52, E43," Occasional Paper Series 217, European Central Bank.
    15. Jean-Philippe Bouchaud & Stanislao Gualdi & Marco Tarzia & Francesco Zamponi, 2018. "Optimal inflation target: insights from an agent-based model," Post-Print hal-01768441, HAL.
    16. Janice C. Eberly & James H. Stock & Jonathan H. Wright, 2019. "The Federal Reserve’s Current Framework for Monetary Policy: A Review and Assessment," NBER Working Papers 26002, National Bureau of Economic Research, Inc.
    17. Bouchaud, Jean-Philippe & Gualdi, Stanislao & Tarzia, Marco & Zamponi, Francesco, 2018. "Optimal inflation target: Insights from an agent-based model," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy (IfW), vol. 12, pages 1-27.

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    More about this item

    Keywords

    macroeconomia; economia internacional;

    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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