How much policy room is gained by an increase of the inflation target?
In this paper, L’Huillier and Schoenle examine whether an increase of the inflation target will proportionally increase the policy room for policymakers. Their main argument is that an increase in the inflation target will trigger a response from the private sector prompting firms to adjust prices more frequently with higher trend inflation. This claim is also supported empirically, as the authors show that there is a clear relationship between the frequency of price changes and trend inflation in the U.S. over the 1970–2015 period. L’Huillier and Schoenle use a 3-equation New Keynesian model which allows them to derive a set of simple theoretical results that highlight how increased price flexibility interacts with a higher target to yield a wedge between intended and effective policy rooms.
We show that the gains generated by this strategy are not one-to-one: Because a higher inflation target leads to a steeper Phillips curve, to effectively get, for instance, 2 percentage points of extra room, policymakers need to raise their inflation target from 2% to 5%. In fact, raising the target from 2% to 4% delivers an effective extra room significantly smaller than 2 percentage points.
Raising the Inflation Target: What Are the Effective Gains in Policy Room?
Authors: Jean-Paul L’Huillier, Raphael Schoenle
From: Brandeis University and Federal Reserve Bank of Cleveland
