Inflation tolerance ranges in the New Keynesian model

Abstract

A number of central banks in advanced countries use ranges, or bands, around their inflation target to formulate their monetary policy strategy. The adoption of such ranges has been proposed by some policymakers in the context of the Fed and the ECB reviews of their strategies. Using a standard New Keynesian macroeconomic model, we analyze the consequences of tolerance range policies, characterized by a stronger reaction of the central bank to inflation when inflation lies outside the range, than when it is close to the target, i.e. the central value of the band. We show that (i) a tolerance band should not be a zone of inaction: the lack of reaction may trigger substantial unwarranted volatility and lead to multiple equilibria; (ii) the trade-off between the reaction needed outside the range versus inside appears unfavorable: a very strong reaction, when inflation is far from the target, is required to compensate for a moderately lower reaction within tolerance band; (iii) these results, obtained within the framework of a stylized model, are robust to many alterations, in particular allowing for the zero lower bound.