The Optimal Inflation Target and the Natural Rate of Interest The Optimal Inflation Target and the Natural Rate of Interest

By Philippe Andrade, Jordi Galí, Hervé Le Bihan, and Julien Matheron

In an environment where the natural real rate of interest is lower, raising the inflation target can mitigate the risk that the nominal interest rate will hit its zero lower bound (ZLB) more frequently, which would hamper the ability of monetary policy to stabilize the economy; however, the authors of this paper point out, there is not an obvious answer to the practical question of how high to raise the target. They argue that determining the optimal inflation target requires an assessment of how the tradeoff between the incidence of ZLB and the welfare cost induced by steady-state inflation is modified when the natural rate of interest decreases.

In addition to examining the extent to which a lower steady-state real interest rate calls for a higher optimal inflation target, this paper looks at whether the source of decline in the interest rate matters, how the parameter uncertainty affects the interest rate-inflation target curve, and the extent to which the strategy and rules followed by the central bank alter the relation between the steady-state real interest rate and the target inflation. The authors focus on the US economy, but their findings apply to other advanced economies, particularly the euro area.

This study employs a New Keynesian DSGE model estimated for the United States over a Great Moderation sample. The framework features price stickiness and partial indexation of prices to trend inflation, wage stickiness and partial indexation of wages to both inflation and productivity, and a ZLB constraint on the nominal interest rate. The first two features imply the presence of potentially substantial costs associated with non-zero steady-state inflation. The third feature warrants a strictly positive inflation rate in order to mitigate the incidence and adverse effects of the ZLB. To the authors’ knowledge, these three features have not been jointly taken into account in previous analyses of optimal inflation.

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