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Changes in the Inflation Target and the Comovement between Inflation and the Nominal Interest Rate

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  • Eo, Yunjong
  • Lie, Denny

Abstract

Would raising the inflation target require an increase in the nominal interest rate in the short run? We answer this policy question, first analytically in a small-scale New Keynesian model with backward-looking components where a closed-form solution exists, and then in a medium-scale model of Smets and Wouters (2007) calibrated to the U.S. economy. Our analysis shows that the short-run comovement between inflation and the nominal interest rate conditional on changes in the inflation target is more likely to be positive, all else equal, as the monetary authority reacts less aggressively to the deviation of inflation from its target. Meanwhile, features of the model that enhance backward-looking behavior, such as backward price indexation and habit formation in consumption, are shown to reduce the likelihood of the positive comovement. However, our investigations reveal that in both models, this positive comovement or so-called Neo-Fisherism is prevalent across a wide-range of empirically-plausible parameter values. Using the Smets and Wouters model with a zero lower bound constraint (ZLB) on the nominal interest rate, we show that raising the inflation target could be an effective alternative policy framework to reduce the possibility of a binding ZLB constraint and to mitigate the potentially large output loss.

Suggested Citation

  • Eo, Yunjong & Lie, Denny, 2018. "Changes in the Inflation Target and the Comovement between Inflation and the Nominal Interest Rate," Working Papers 2018-02, University of Sydney, School of Economics, revised May 2020.
  • Handle: RePEc:syd:wpaper:2018-02
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    References listed on IDEAS

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    1. Saroj Bhattarai & Jae Won Lee & Woong Yong Park, 2016. "Policy Regimes, Policy Shifts, and U.S. Business Cycles," The Review of Economics and Statistics, MIT Press, vol. 98(5), pages 968-983, December.
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    More about this item

    Keywords

    Neo-Fisherism; zero lower bound; inflation expectations; Taylor-type rule; hybrid NKPC; hybrid IS curve;
    All these keywords.

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • 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

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