Average inflation targeting and the interest rate lower bound

Monetary Policy Strategies for the Euro Area: Optimal Rules in the Presence of the ELB

“…But we contribute to the literature by computing optimal simple rules and showing that the differences in performance with respect to inflation targeting and across makeup strategies are greatly reduced when we use optimized response coefficients. 2 Fourth, while early literature has typically assumed that the policy strategy is fully credible and well understood, see for instance Kiley and Roberts (2017), we contribute to the research pointing to the crucial role of expectations formation in determining the performance of makeup strategies, see Bernanke, Kiley, and Roberts (2019), Amano, Gnocchi, Leduc, and Wagner (2020), Budianto, Nakata, and Schmidt (2020), and Busetti, Neri, Notarpietro, and Pisani (2021. 3 We show that policy promises of lower-for-longer embedded in makeup strategies increase in power the more the model suffers from excess sensitivity of inflation to interest rate expectations -the forward guidance puzzle.…”

The Consequences of Falling Behind the Curve: Inflation Shocks and Policy Delays Under Rational and Behavioral Expectations

“…Sims contrasted this view with that of Hansen and Sargent (2002) who he characterized as "...recommending to policy-makers the same sub-rational behavior that they postulate in private agents." We are sympathetic with Sims' position, and note that Gabaix (2020) employs the standard loss appropriate under rational expectations in his analysis of optimal policy when private agents display cognitive discounting, as do Budianto, Nakata, and Schmidt (2023) in their analysis of average inflation targeting. 18) is achieved if k = 0, that is, if policy reacts immediately to the shock.…”

“…The cognitive discounting approach has been used by Budianto, Nakata, and Schmidt (2023) to evaluate average inflation targeting relative to inflation targeting. They find that while price level targeting dominates finite-period average inflation targeting under rational expectations, this is no longer the case with boundedly rational expectations, unless the deviation of expectations from rational expectations is small.…”

Make-Up Strategies with Incomplete Markets and Bounded Rationality

“…For instance, Vestin (2006) shows that, under certain conditions, the that highlight the limitations of make-up strategies in New Keynesian models with bounded rationality (see e.g. Budianto et al, 2020;Honkapohja and Mitra, 2020;Mele et al, 2020;Erceg et al, 2021;Bodenstein et al, 2022;Dupraz et al, 2022). 11 In contrast to these studies, our analysis is not restricted to a RANK environment but allows for household heterogeneity and market incompleteness.…”