The Inflation Target and the Equilibrium Real Rate The Inflation Target and the Equilibrium Real Rate

Many economists have proposed raising the inflation target from 2 percent to 4 percent, claiming that doing so will raise nominal interest rates and thus reduce the probability of hitting the zero lower bound (ZLB). It is widely assumed that raising the inflation target will not affect the equilibrium real interest rate and therefore raising the inflation target by 2 percentage points will raise the equilibrium nominal rate by a corresponding 2 percentage points.

This paper presents a new channel by which raising the inflation target lowers the equilibrium real rate. The IMR channel has two stages. First, price rigidities imply that a rise in the inflation target lowers firms’ markup (the ratio of their price to their nominal marginal cost). Second, household heterogeneity (through overlapping generations or idiosyncratic risk) implies that a fall in the markup lowers the equilibrium real rate. The author therefore refers to the channel as the inflation markup real rate (IMR) channel.

More specifically, a fall in the markup lowers firms’ profits and reduces the value of shares and the value of overall savings. A fall in the value of savings, all else being equal, lowers the consumption of old people relative to that of young people, which means that the old have higher marginal utility from consuming compared with the young. Therefore, there is greater competition among young people to save for when they are old, and so the price of savings rises. As it rises, the return on savings (the equilibrium real rate) falls. If the equilibrium real rate drops, then the nominal rate will not rise as much as expected when inflation rises, and therefore, raising the inflation target will reduce the probability of hitting the ZLB by less than is commonly believed.

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