DP14400 Average Inflation Targeting and the Interest Rate Lower Bound

Author(s): Flora Budianto, Taisuke Nakata, Sebastian Schmidt
Publication Date: February 2020
Keyword(s): Average Inflation Targeting, Deflationary Bias, liquidity trap, Makeup Strategies, Monetary Policy Objectives
JEL(s): E31, E52, E58, E61
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14400

A discretionary central bank with a mandate to stabilize an average inflation rate---rather than period-by-period inflation---increases welfare of a sticky-price economy in which nominal interest rates are occasionally constrained by a lower bound. The welfare gain is driven by two monetary policy motives that arise in the presence of an average inflation objective: the history-dependence motive makes expected future inflation an increasing function of current inflation shortfalls, and vice versa, acting as an automatic stabilizer; and the lower bound risk motive induces the central bank to raise inflation when the risk of hitting the lower bound constraint increases. Under rational expectations, the optimal averaging window is infinitely long, so that the optimal average inflation targeting framework is tantamount to price level targeting. Most of the welfare improvement can, however, be attained by a framework with a finite, but sufficiently long, averaging window. Under boundedly-rational expectations, if cognitive limitations are sufficiently strong, the optimal averaging window is finite, and the welfare gain of adopting an average inflation target can be small.