Optimal Inflation Target: Insights from an Agent-Based Model

TL;DR

This paper uses an agent-based model to explore optimal inflation targets, revealing that very low targets can be harmful and that higher targets may improve economic stability and employment.

Contribution

It introduces a novel agent-based model to analyze how different inflation targets affect macroeconomic stability and compares results with traditional DSGE models.

Findings

Low inflation targets can lead to persistent under-inflation.

Higher inflation targets improve employment and reduce negative interest episodes.

The model exhibits multiple macroeconomic states, including hyper-inflation and deflation.

Abstract

Which level of inflation should Central Banks be targeting? We investigate this issue in the context of a simplified Agent Based Model of the economy. Depending on the value of the parameters that describe the behaviour of agents (in particular inflation anticipations), we find a rich variety of behaviour at the macro-level. Without any active monetary policy, our ABM economy can be in a high inflation/high output state, or in a low inflation/low output state. Hyper-inflation, deflation and "business cycles" between coexisting states are also found. We then introduce a Central Bank with a Taylor rule-based inflation target, and study the resulting aggregate variables. Our main result is that too-low inflation targets are in general detrimental to a CB-monitored economy. One symptom is a persistent under-realisation of inflation, perhaps similar to the current macroeconomic situation. Higher inflation targets are found to improve both unemployment and negative interest rate episodes. Our results are compared with the predictions of the standard DSGE model.