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Inflation Targets and the Zero Lower Bound in a Behavioural Macroeconomic Model
Author(s) -
De Grauwe Paul,
Ji Yuemei
Publication year - 2019
Publication title -
economica
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.532
H-Index - 65
eISSN - 1468-0335
pISSN - 0013-0427
DOI - 10.1111/ecca.12261
Subject(s) - economics , pessimism , zero lower bound , inflation (cosmology) , recession , keynesian economics , optimism , dominance (genetics) , macroeconomic model , output gap , new keynesian economics , monetary economics , animal spirits , inflation targeting , monetary policy , psychology , social psychology , philosophy , biochemistry , physics , chemistry , epistemology , theoretical physics , gene
We analyse the relationship between the level of the inflation target and the zero lower bound imposed on the nominal interest rate in the framework of a behavioural New‐Keynesian macroeconomic model in which agents, experiencing cognitive limitations, use adaptive learning forecasting rules. The model produces endogenous waves of optimism and pessimism (animal spirits) that lead to non‐normal distributions of the output gap. We find that when the inflation target is too close to zero, the economy can get gripped by ‘chronic pessimism’ that leads to a dominance of negative output gaps and recessions, and in turn feeds back on expectations producing long waves of pessimism. Low inflation targets create the risk of persistence of recessions and low growth. In conclusion, our framework suggests that the 2% inflation target, now pursued by many central banks, is too low.