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Working Paper

Raising the Inflation Target: How Much Extra Room Does It Really Give?

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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.
Topics
Inflation
Monetary policy
06.16.2020ISSN 2573-7953 WP 20-16DOI 10.26509/frbc-wp-202016
Keywords timidity trap, zero lower bound, liquidity traps, central bank design, inflation targeting, lucas proof, price stability
JEL Classification Codes E31, E52, E58

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

L’Huillier, Jean-Paul, and Raphael S. 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