DP11320 Inflation Targets and the Zero Lower Bound In a Behavioral Macroeconomic Model

Author(s): Paul De Grauwe, Yuemei Ji
Publication Date: June 2016
Keyword(s): behavioral macroeconomics, Inflation targeting, zero lower bound
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11320

We analyze the relation between the level of the inflation target and the zero lower bound (ZLB) imposed on the nominal interest rate. We analyze this relation in the framework of a behavioral macroeconomic model in which agents experience cognitive limitations. The model produces endogenous waves of optimism and pessimism (animal spirits) that, because of their self-fulfilling nature, drive the business cycle and in turn are influenced by the business cycle. We find that when the inflation target is too close to zero, the economy can get gripped by "chronic pessimism"? that leads to a dominance of negative output gaps and recessions, and in turn feeds back on expectations producing long waves of pessimism. The simulations of our model, using parameter calibrations that are generally found in the literature, suggests that an inflation target of 2% is too low, i.e. produces negative skewness in the distribution of the output gap. We find that an inflation target in the range of 3% to 4% comes closer to producing a symmetric distribution of the output gap and avoids the economy being trapped in a region of chronic pessimism.