Raising the Inflation Target: How Much Extra Room Does It Really Give?
Some, but less than intended. The reason is a shift in the behavior of the private sector: Prices adjust more frequently, lowering the potency of monetary policy. We quantitatively investigate this channel across different models, based on a calibration using micro data. By raising the target from 2 percent to 4 percent, the monetary authority gets only between 0.51 and 1.60 percentage points of effective extra policy room for monetary policy (not 2 percentage points as intended). Getting 2 percentage points of effective extra room requires raising the target to more than 4 percent. Taking this channel into consideration raises the optimal inflation target by roughly 1 percentage points relative to earlier computations.
JEL Classification: E31, E52, E58.
Keywords: timidity trap, zero lower bound, liquidity traps, central bank design, inflation targeting, Lucas proof, price stability.
Note: When first posted on 6/16/2020, the paper’s in-text citations were malformed. This version, posted 6/24/2020, corrects this issue.
Suggested citation: L’Huillier, Jean-Paul, and Raphael Schoenle. 2020. “Raising the Inflation Target: How Much Extra Room Does It Really Give?” Federal Reserve Bank of Cleveland, Working Paper No. 20-16. https://doi.org/10.26509/frbc-wp-202016.