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Average inflation targeting and the interest rate lower bound

Author

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

Abstract

Assigning a discretionary central bank a mandate to stabilize an average inflation rate—rather than a period-by-period inflation rate—increases welfare in a New Keynesian model with an occasionally binding lower bound on nominal interest rates. Under rational expectations, the welfare-maximizing averaging window is infinitely long, which means that optimal average inflation targeting (AIT) is equivalent to price level targeting (PLT). However, AIT with a finite, but sufficiently long, averaging window can attain most of the welfare gain from PLT. Under boundedly-rational expectations, if cognitive limitations are sufficiently strong, the optimal averaging window is finite, and the welfare gain of adopting AIT can be small. JEL Classification: E31, E52, E58, E61, E71

Suggested Citation

  • Nakata, Taisuke & Schmidt, Sebastian & Budianto, Flora, 2020. "Average inflation targeting and the interest rate lower bound," Working Paper Series 2394, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20202394
    Note: 2179645
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    More about this item

    Keywords

    deflationary bias; expectations; liquidity trap; makeup strategies; monetary policy objectives;
    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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