Average Inflation Targeting and the Interest Rate Lower Bound
29 Pages Posted: 15 Apr 2020
Date Written: April 2, 2020
Assigning a discretionary central bank a mandate to stabilize an average inflation rate - rather than a period-by-period inflation rate - increases welfare in a New Keynesian model with an occasionally binding lower bound on nominal interest rates. Under rational expectations, the welfare-maximizing averaging window is infinitely long, which means that optimal average inflation targeting (AIT) is equivalent to price level targeting (PLT). However, AIT with a finite, but sufficiently long, averaging window can attain most of the welfare gain from PLT. Under boundedly-rational expectations, if cognitive limitations are sufficiently strong, the optimal averaging window is finite, and the welfare gain of adopting AIT can be small.
Keywords: monetary policy objectives, makeup strategies, liquidity trap, deflationary bias, expectations
JEL Classification: E31, E52, E58, E61, E71
Suggested Citation: Suggested Citation