Optimal inflation target with expectations-driven liquidity traps

Abstract

In expectations-driven liquidity traps (LTs), a higher inflation target is associated with lower inflation and consumption. As a result, introducing the possibility of expectations-driven LTs to an otherwise standard model lowers the optimal inflation target. Using a calibrated New Keynesian model with an effective lower bound (ELB) constraint on nominal interest rates, we find that even a very small probability of falling into an expectations-driven LT lowers the optimal inflation target nontrivially. Our analysis provides a novel reason to be cautious about the argument that central banks should raise their inflation targets in light of a higher likelihood of hitting the ELB.