Raising the Inflation Target Rate to Evade the Zero Lower Bound
| Raising the inflation target rate to evade the Zero Lower Bound | Econ 134 GSI: Yury Yatsynovich | | Deepak Ravichandran | 4/17/2012 |
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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. In these more recent times, the Federal Reserve has struggled to stimulate an economy that has been launched into a recession by a global financial crisis. Their normal practice of lowering the federal funds rate became ineffective as the nominal interest rate approached the Zero Lower Bound (ZLB). Monetary policy fell into the “liquidity trap”, with the Federal Reserve running out of room to lower the nominal interest rate through open-market operations. As a result of this situation, many leading economists, including Olivier Blanchard, head of the International Monetary Fund (IMF), clamored for an increase in the target inflation rate, from its historical level of two percent to four percent, in order to give the Federal Reserve more room to lower the federal funds rate (and thus the real interest rate) before it reaches the ZLB (Blanchard, 2010). This paper aims to evaluate the validity of this claim through its basis in economic history and research, and finally makes a recommendation as to its adoption. This will be done in a three-pronged approach, first looking at empirical case-study evidence presented by the Japanese ZLB crisis between 2001-2006, and supplementing this with economic research and models being done on the
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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. In these more recent times, the Federal Reserve has struggled to stimulate an economy that has been launched into a recession by a global financial crisis. Their normal practice of lowering the federal funds rate became ineffective as the nominal interest rate approached the Zero Lower Bound (ZLB). Monetary policy fell into the “liquidity trap”, with the Federal Reserve running out of room to lower the nominal interest rate through open-market operations. As a result of this situation, many leading economists, including Olivier Blanchard, head of the International Monetary Fund (IMF), clamored for an increase in the target inflation rate, from its historical level of two percent to four percent, in order to give the Federal Reserve more room to lower the federal funds rate (and thus the real interest rate) before it reaches the ZLB (Blanchard, 2010). This paper aims to evaluate the validity of this claim through its basis in economic history and research, and finally makes a recommendation as to its adoption. This will be done in a three-pronged approach, first looking at empirical case-study evidence presented by the Japanese ZLB crisis between 2001-2006, and supplementing this with economic research and models being done on the