Evaluating Higher Inflation Targets
Critically evaluate the argument that central banks should adopt an inflation target higher than the conventional 2%. In your answer, explain the specific constraint on monetary policy that this proposal aims to address, and describe the mechanism by which a higher inflation target would help overcome this constraint during a recession.
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Two countries are facing a severe economic recession. Both of their central banks determine that to stimulate economic activity, they need to achieve a target real interest rate of -3%. Country A has historically maintained an average inflation rate of 1%. Country B has historically maintained an average inflation rate of 4%. Assuming both central banks cut their nominal policy interest rates as low as they can go (to zero), which of the following outcomes is most likely?
Central Bank Policy Flexibility
Central Bank Policy Dilemma
If a central bank is constrained by the fact that it cannot set its policy interest rate below zero, a higher prevailing rate of inflation makes it more difficult for the bank to achieve a negative real interest rate to stimulate the economy.
Evaluating Higher Inflation Targets