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