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The Optimal Inflation Target and the Natural Rate of Interest

Author

Listed:
  • Philippe Andrade
  • Jordi Gali
  • 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 lower steady-state real interest rate increases the probability of hitting the lower bound. That effect can be counteracted by an increase in the inflation target, but the resulting higher steady-state inflation has a welfare cost in and of itself. We use an estimated DSGE model to quantify that tradeoff and determine the implied optimal inflation target, conditional on the monetary policy rule in place before the financial crisis. The relation between the steady-state real interest rate and the optimal inflation target is downward sloping. While the increase in the optimal inflation rate is in general smaller than the decline in the steady-state real interest rate, in the currently empirically relevant region the slope of the relation is found to be close to –1. That slope is robust to allowing for parameter uncertainty. Under “make-up” strategies such as price level targeting, the required increase in the optimal inflation target under a lower steady-state real interest rate is, however, much smaller.

Suggested Citation

  • Philippe Andrade & Jordi Gali & Hervé Le Bihan & Julien Matheron, 2019. "The Optimal Inflation Target and the Natural Rate of Interest," Working Papers 19-18, Federal Reserve Bank of Boston.
    • Handle: RePEc:fip:fedbwp:87412
    DOI: 10.29412/res.wp.2019.18
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    More about this item

    Keywords

    inflation target; effective lower bound; natural interest rate; steady-state real interest rate;
    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

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