Average Inflation Targeting and the Interest Rate Lower Bound
31 Pages Posted: 20 Apr 2020
Date Written: April, 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: deflationary bias, expectations, liquidity trap, makeup strategies, monetary policy objectives
JEL Classification: E31, E52, E58, E61, E71
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