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Inflation targets and the zero lower bound in a behavioural macroeconomic model

De Grauwe, Paul and Ji, Yuemei (2019) Inflation targets and the zero lower bound in a behavioural macroeconomic model. Economica, 86 (342). pp. 262-299. ISSN 0013-0427

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Identification Number: 10.1111/ecca.12261

Abstract

We analyse the relationship between the level of the inflation target and the zero lower bound imposed on the nominal interest rate in the framework of a behavioural New-Keynesian macroeconomic model in which agents, experiencing cognitive limitations, use adaptive learning forecasting rules. The model produces endogenous waves of optimism and pessimism (animal spirits) that lead to non-normal distributions of the output gap. We find that when the inflation target is too close to zero, the economy can get gripped by ‘chronic pessimism’ that leads to a dominance of negative output gaps and recessions, and in turn feeds back on expectations producing long waves of pessimism. Low inflation targets create the risk of persistence of recessions and low growth. In conclusion, our framework suggests that the 2% inflation target, now pursued by many central banks, is too low.

Item Type: Article
Additional Information: © 2017 The London School of Economics and Political Science
Divisions: European Institute
Date Deposited: 20 Mar 2019 12:15
Last Modified: 14 Aug 2019 23:11
URI: http://eprints.lse.ac.uk/id/eprint/100264

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