Inflation Targets and the Zero Lower Bound

Abstract

Does a higher inflation target for central banks help to reduce the risk of hitting the zero lower bound (ZLB) on nominal interest rates? In the standard New Keynesian model, a higher inflation target changes the price-setting behavior of firms in a substantial way. Specifically, firms become more forward-looking, inflation is more volatile and, thereby, the nominal interest rate fluctuates more. I show that even with more "room-to-manoeuvre" for the nominal interest rate due to a higher inflation target, the higher volatility of the nominal interest rate implies that the economy can end up - on net - more often at the ZLB. I provide an example in which a 4% inflation target can, in fact, increase the risk of hitting the ZLB relative to a 2% inflation target.