Year: 2019
Type: article
Abstract: We study how changes in the steady-state real interest rate (henceforth r*) affect the optimal inflation target in a New Keynesian dynamic stochastic general equilibrium (DSGE) model with trend inflation and a lower bound on the nominal interest rate.In this setup, a lower r* 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 trade-off and determine the implied optimal inflation target, conditional on the monetary policy rule in place before the financial crisis.The relation between r* and the optimal inflation target is downward sloping.While the increase in the optimal inflation rate is in general smaller than the decline in r*, 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.
Language: English
Domain: Social Sciences
Open Access status: bronze
Funders: Sveriges Riksbanken, Deutsche Bundesbank
OpenAlex ID: W4288860177