Average Inflation Targeting and the Interest Rate Lower Bound

31 Pages Posted: 20 Apr 2020

See all articles by Taisuke Nakata

Taisuke Nakata

Board of Governors of the Federal Reserve System

Sebastian Schmidt

European Central Bank (ECB)

Flora Budianto

Bank for International Settlements (BIS)

Multiple version iconThere are 3 versions of this paper

Date Written: April, 2020

Abstract

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

Suggested Citation

Nakata, Taisuke and Schmidt, Sebastian and Budianto, Flora, Average Inflation Targeting and the Interest Rate Lower Bound (April, 2020). ECB Working Paper No. 2394, Available at SSRN: https://ssrn.com/abstract=3578543

Taisuke Nakata (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Sebastian Schmidt

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Flora Budianto

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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