A prolonged decline in the natural rate of interest across developed countries has increased a likelihood of hitting the effective lower bound (ELB). This leads to questions about the superiority of the inflation targeting regime for current macroeconomic environment. The aim of my research is to investigate different monetary policy regimes within the various spectrum of macroeconomic models, mainly incorporating heterogeneous structure of household sector.
Frequently discussed alternative regimes, namely average inflation targeting (AIT), price level targeting (PLT), and nominal GDP level targeting (nGDPLT) should be examine and compare within DSGE models to better understand their pros and cons in juxtaposition with the inflation targeting regime.
The regimes must be compared in models containing occasionally binding constraint (OBC) to be able to simulate the ELB situation. Furthermore, the regimes should be compared within the wide range of models, i.e. not only considering both closed economy models and open small economy models (hence, my research is devoted rather to SOE models that has not gotten so much attention in similar analysis so far) but it is crucial to investigate the monetary policy rules when taking account numerous extensions. Specifically, I am focused mainly on the incorporation of the heterogeneous agents in terms of wealth distribution and possibility of intertemporal substitution in consumption (e.g. using the versions of TANK or HANK models) or on the role of expectations (e.g. working with heterogeneous expectation models based on Branch and McGough, 2009, Massaro, 2013 or Gabaix, 2019).
A comparison of the regimes under different models with many additional features is the only way how to make the results of the casual analysis of potential change of the monetary policy rule as robust as possible. Moreover, the rational agent assumption in benchmark New Keynesian (NK) models is most questionable part of this sort of analysis.
Up to now, all similar analyzes have been conducted for the case of closed economy model calibrated for the US or EMU (see Amano et al., 2020, Budianto, Nakata, and Schmidt, 2020 or Feiveson et al., 2020). I want to focus my analysis rather on a small open economy (SOE) model so my model would be in the first stage similar to TANK SOE models used for example in Iyer (2017), Boerma (2014), Cugat (2019), Eser (2009), or Motyovszki (2021). Later on, when I would like to work also with HANK models, I would follow models used in Ferra, Mitman, and Romei (2020) or Auclert et al (2021).
Based on an observation related to the change that Fed made last year, I think the main question concerning AIT is what is the optimal period across which the central bank should average inflation. I see this issue as a highly peculiar one, so it is not surprising that Fed still hesitates to define the period explicitly until they have a solid rationale behind it. If the period is too short, the result can be an impossibility to satisfy the makeup property of the regime and everything boils down back to the inflation targeting. On the other hand, if the period is too long, it can have zero effect in the current time. For example, imagine the case of price level targeting, where no exact time until which the targeting variable must return to the target path exists and the central bank only promises to return to the path in an infinite horizon. Thus, no mechanism could push inflation expectations higher (assume a negative demand shock in the proximity of the ZLB as this is a relevant issue for this kind of discussion) in the near time. The central bank then can undershoot the target until accumulating such a huge deviation that the promise to come back to the target path becomes completely non-credible and irrelevant.
However, there is no strong evidence upon which it would be possible to determine the optimal average inflation period in AIT regime. One approach, that also I want to use in my analysis, is to choose the period according to the welfare analysis. This is the way Amano et al. (2020) or Budianto, Nakata, and Schmidt (2020) proceed with the case of a closed economy model. They calculate the optimal history dependence feature by maximizing the household welfare in both cases when the ZLB is not binding as well as when it is present in the model.
To my knowledge, computing the optimal averaging period in AIT and comparing AIT, PLT, and nGDPLT to IT in a broad variety of heterogeneous agents SOE models when taking into account the lower bound for the nominal interest rate can bring an element of novelty to current literature.
-----------------------------------------------
Amano, R., Gnocchi, S., Leduc, S., and Wagner, J., 2020. "Average Is Good Enough: Average-Inflation Targeting and the ELB," Working Paper Series 2020-21, Federal Reserve Bank of San Francisco.
Nakata, T., Schmidt, S., and Budianto, F., 2020. "Average inflation targeting and the interest rate lower bound," Working Paper Series 2394, European Central Bank.
Feiveson, L. J., Gornemann, N., Hotchkiss, J. L., Mertens, K., and Sim, J. W., 2020. "Distributional Considerations for Monetary Policy Strategy," Finance and Economics Discussion Series 2020-073, Board of Governors of the Federal Reserve System (U.S.).
Iyer, T., 2017. ¿Optimal Monetary Policy in an Open Emerging Market Economy,¿ Federal
Reserve Bank of Chicago Working Paper, (WP 2016-06).
Boerma, J., 2014. ¿Openness and the (inverted) aggregate demand logic,¿ DNB Working
Paper, (436).
Cugat, G. 2019. ¿Emerging markets, household heterogeneity, and exchange rate policy,¿ mimeo - Northwestern University
Eser, F., 2009. "Monetary Policy in a Currency Union with Heterogeneous Limited Asset Markets Participation," Economics Papers 2009-W16, Economics Group, Nuffield College, University of Oxford.
Motyovszki, G., 2021. "Monetary-Fiscal Interactions and Redistribution in Small Open Economies," Economics Working Papers EUI ECO 2020/03, European University Institute.
de Ferra, S, Mitman, K., and Romei, F., 2020. "Household heterogeneity and the transmission of foreign shocks," Journal of International Economics, Elsevier, vol. 124(C).
Auclert, A., Rognlie, M., Souchier, M., Straub, L., 2021. "Exchange Rates and Monetary Policy with Heterogeneous Agents: Sizing up the Real Income Channel," NBER Working Papers 28872, National Bureau of Economic Research, Inc.