Raising the Inflation Target Rate to Evade the Zero Lower Bound

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| Raising the inflation target rate to evade the Zero Lower Bound | Econ 134 GSI: Yury Yatsynovich | | Deepak Ravichandran | 4/17/2012 |


From its inception, the central bank’s onus has always been a dual mandate; to maintain maximum employment while at the same time keeping stable prices. While we as economists have learned much about the mechanism through which monetary policy affects the economy, much is still unknown about the inner workings of the economy, and the long-term effects of varying monetary policy. Over the past two decades, the Federal Reserve has dictated that the inflation target rate should be close to two percent for the American economy, yet this idea has come into question in the past 5 years. …show more content…

For a given amount of central bank spending, the influence on asset prices is minimal when compared to traditional FOMC open-market operations’ ability to influence the federal funds rate due to the relative sizes of the markets for the assets being purchased/sold (Rognlie, 2011). In addition, the purchase of risky assets places undue risk on the Fed’s balance sheet, which runs counter to the traditional goal of the Federal Reserve and expands the balance sheet of the Fed with assets that can often be illiquid (Delong, 2011). This deficiency of quantitative easing as a method of economic stimulation was evidenced in the Japanese crisis, when quantitative easing did not provide the permanent relief necessary to bring Japan back to its target inflation level, and thus it is extremely necessary that the government retain traditional monetary policy tools in order to avoid the ZLB.
Another interesting feature of the Japanese crisis is the inflation rate target set by the Japanese government during the 2001-2006 period. Widely acknowledged estimates show that the Bank of Japan maintained a conventional Taylor-type reaction function with a strong emphasis on inflation stabilization, and an implicit inflation target of about 1% during this time period (Leigh, 2009). Counterfactual models run by Daniel Leigh, an IMF Economist, show that an increase of this target inflation rate to 4% coupled with greater responses to output gaps (through a larger output coefficient in

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