The Optimal Inflation Target and the Natural Rate of Interest

By Philippe Andrade, Jordi Galí, Hervé Le Bihan and Julien Matheron

http://d.repec.org/n?u=RePEc:bge:wpaper:1009&r=dge

We study how changes in the value of the steady-state real interest rate affect the optimal inflation target, both in the U.S. and the euro area, using an estimated New Keynesian DSGE model that incorporates the zero (or effective) lower bound on the nominal interest rate. We find that this relation is downward sloping, but its slope is not necessarily one-for-one: increases in the optimal inflation rate are generally lower than declines in the steady-state real interest rate. Our approach allows us not only to assess the uncertainty surrounding the optimal inflation target, but also to determine the latter while taking into account the parameter uncertainty facing the policy maker, including uncertainty with regard to the determinants of the steady-state real interest rate. We find that in the currently empirically relevant region for the US as well as the euro area, the slope of the curve is close to -0.9. That finding is robust to allowing for parameter uncertainty.

Economists are now fairly convinced that the real interest rate has declined, whatever the reason may be. In that context, some of the policy “constants” need to be reevaluated, as they may depend on the real interest rate. This paper is one important approach at this question for the inflation target using a New Keynesian model. Let’s see whether other approaches come to similar conclusions.