Raising the Inflation Target: What Are the Effective Gains in Policy Room?

The zero lower bound on interest rates has prompted policymakers to consider raising their inflation target to regain policy room. We show that the gains generated by this strategy are not one-to-one: Because a higher inflation target leads to a steeper Phillips curve, to effectively get, for instance, 2 percentage points of extra room, policymakers need to raise their inflation target from 2% to 5%. In fact, raising the target from 2% to 4% delivers an effective extra room significantly smaller than 2 percentage points. Taking this mechanism into consideration changes the optimal inflation target. When the natural rate is near zero, the optimal inflation target is 1 percentage point higher than the optimal target obtained by conventional, earlier, calculations.