DP14142 Raising the Inflation Target: How Much Extra Room Does It Really Give?

Author(s): Jean-Paul Lhuillier, Raphael Schoenle
Publication Date: November 2019
Keyword(s): central bank design, Inflation targeting, liquidity traps, Lucas proof, price stability, Timidity trap, zero lower bound
JEL(s): E31, E52, E58
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14142

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.