The optimal inflation target and the natural rate of interest
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 b...
| Main Authors: | , , , |
|---|---|
| Format: | Journal Article |
| Published: |
Brookings Institution Press
2019
|
| Subjects: | |
| Online Access: | http://hdl.handle.net/20.500.11937/81197 |
| _version_ | 1848764332885671936 |
|---|---|
| author | Le Bihan, Herve Gali, Jordi Andrade, Philippe Matheron, Julien |
| author_facet | Le Bihan, Herve Gali, Jordi Andrade, Philippe Matheron, Julien |
| author_sort | Le Bihan, Herve |
| building | Curtin Institutional Repository |
| collection | Online Access |
| description | 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 steadystate inflation has a welfare cost in and of itself. We use an estimated DSGE model to quantify that
trade-off 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 lower steady-state real interest rate is, however, much smaller. |
| first_indexed | 2025-11-14T11:17:41Z |
| format | Journal Article |
| id | curtin-20.500.11937-81197 |
| institution | Curtin University Malaysia |
| institution_category | Local University |
| last_indexed | 2025-11-14T11:17:41Z |
| publishDate | 2019 |
| publisher | Brookings Institution Press |
| recordtype | eprints |
| repository_type | Digital Repository |
| spelling | curtin-20.500.11937-811972020-10-01T07:39:23Z The optimal inflation target and the natural rate of interest Le Bihan, Herve Gali, Jordi Andrade, Philippe Matheron, Julien Inflation target, Effective lower bound, Natural Interest Rate, Steady-State Real Interest Rate 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 steadystate inflation has a welfare cost in and of itself. We use an estimated DSGE model to quantify that trade-off 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 lower steady-state real interest rate is, however, much smaller. 2019 Journal Article http://hdl.handle.net/20.500.11937/81197 Brookings Institution Press fulltext |
| spellingShingle | Inflation target, Effective lower bound, Natural Interest Rate, Steady-State Real Interest Rate Le Bihan, Herve Gali, Jordi Andrade, Philippe Matheron, Julien The optimal inflation target and the natural rate of interest |
| title | The optimal inflation target and the natural rate of interest |
| title_full | The optimal inflation target and the natural rate of interest |
| title_fullStr | The optimal inflation target and the natural rate of interest |
| title_full_unstemmed | The optimal inflation target and the natural rate of interest |
| title_short | The optimal inflation target and the natural rate of interest |
| title_sort | optimal inflation target and the natural rate of interest |
| topic | Inflation target, Effective lower bound, Natural Interest Rate, Steady-State Real Interest Rate |
| url | http://hdl.handle.net/20.500.11937/81197 |