JVM Seminar: Paul de Grauwe (LSE)

May 30, 2017, 17:00 - 18:30, IHS, Lecture Room E02

Inflation targets and the zero lower bound in a behavioral macroeconomic model

Paul de Grauwe (LSE)

We analyse the relation between the level of the inflation target and the zero lower bound (ZLB) imposed on the nominal interest rate in the framework of a behavioral 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. We conclude that the 2% inflation target, now pursued by many central banks, is too low.

paper jointly with Yuemei Ji (University College London)