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