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Discussion Paper Details

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Title: Raising the Inflation Target: How Much Extra Room Does It Really Give?

Author(s): Jean-Paul L'Huillier and Raphael Schoenle

Publication Date: November 2019

Keyword(s): central bank design, Inflation targeting, liquidity traps, Lucas proof, price stability, Timidity trap and zero lower bound

Programme Area(s): Monetary Economics and Fluctuations

Abstract: Less than intended. Therefore, in order to get, say, 2 pp. of extra room for monetary policy, the target needs to be raised to more than 4%. In this paper, we investigate the constraints on a policy aimed at achieving more monetary policy room by raising the inflation target. A theoretical analysis shows that the actual effective room gained when raising the target is always smaller than the intended room. The reason is a shift in the behavior of the private sector: Prices adjust more frequently, lowering the potency of monetary policy. We derive a simple formula for the effective gain expressed in terms of the potency of monetary policy. We then quantitatively investigate this channel across different models, based on a calibration using micro data. We find that, by raising the target to 4%, the monetary authority only gains between 0.51 and 1.60 percentage points (pp.) of policy room (not 2 pp. as intended). In order to achieve 2 pp. additional policy room, the target needs to be raised to approximately 5%. The quantitative models allow to derive the Bayesian distribution of the effective room under parameter uncertainty.

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Bibliographic Reference

L'Huillier, J and Schoenle, R. 2019. 'Raising the Inflation Target: How Much Extra Room Does It Really Give?'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14142