Working Paper: CEPR ID: DP14400
Authors: Flora Budianto; Taisuke Nakata; Sebastian Schmidt
Abstract: Under conventional inflation targeting (IT), the lower bound on nominal interest rates gives rise to a systematic downward bias in inflation that substantially reduces welfare. Using two variants of a New Keynesian model, we investigate whether a monetary policy strategy that aims to stabilize an average inflation rate---rather than a period-by-period inflation rate---leads to better outcomes. With rational expectations, price level targeting (PLT)---the limiting case of average inflation targeting (AIT)---is optimal, yet AIT with sufficient history dependence reaps most of the benefits of PLT. With boundedly rational expectations, PLT is no longer optimal unless the degree of bounded rationality is small. When deviations from rational expectations are sufficiently large, outcomes can be worse under PLT or AIT with strong history dependence than under IT. Finally, for both variants of the model, inflation conservatism improves welfare by eliminating the deflationary bias without invoking history dependence.
Keywords: monetary policy; objectives; makeup strategies; liquidity trap; deflationary bias
JEL Codes: E31; E52; E58; E61; E71
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Average Inflation Targeting (AIT) (E63) | welfare (I38) |
| Conventional Inflation Targeting (IT) (E52) | welfare (I38) |
| Average Inflation Targeting (AIT) (E63) | history dependence (N00) |
| history dependence (N00) | future inflation expectations (E31) |
| Average Inflation Targeting (AIT) (E63) | stabilization outcomes at the lower bound (C62) |
| Boundedly Rational Expectations (D84) | welfare improvements from AIT (I38) |
| Cognitive Limitations (D91) | effectiveness of AIT (C45) |