Chris Cotton
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Job Market Paper

The Inflation Target and the Equilibrium Real Rate

Many economists have proposed raising the inflation target to reduce the probability of hitting the zero lower bound (ZLB). It is both widely assumed and a feature of standard models that raising the inflation target does not impact the equilibrium real rate. I demonstrate that once heterogeneity is introduced, raising the inflation target causes the equilibrium real rate to fall in the New Keynesian model. This implies that raising the inflation target will increase the nominal interest rate by less than expected and thus will be less effective in reducing the probability of hitting the ZLB. The channel is that a rise in the inflation target lowers the average markup by price rigidities and a fall in the average markup lowers the equilibrium real rate by household heterogeneity which could come from overlapping generations or idiosyncratic labor shocks. Raising the inflation target from 2% to 4% lowers the equilibrium real rate by 0.38 percentage points in my baseline calibration. I also analyse the optimal inflation level and provide empirical evidence in support of the model mechanism.

Other Working Papers

A Long-Term Behavioral New Keynesian Model

The Behavioral New Keynesian model appears to offer a simple way to resolve many paradoxes within Macroeconomics. I demonstrate, however, that a key feature of the model is that the irrational part of agents' expectations are fixed at the steady state level. I relax this assumption and allow for the irrational part of expectations to update slowly in line with what agents observe. I derive an alternative Behavioral New Keynesian model within this long-term expectations framework. In this case, a fixed nominal interest rate rule is not determinate and the zero lower bound does not have bounded costs. Thus, important paradoxes remain unresolved. This contrasts with Gabaix (2018).

Data Revisions as Shocks (with Emi Nakamura and Jón Steinsson)

Recent work has attempted to make use of macroeconomic data revisions as exogenous shocks to beliefs and policy. We discuss some of the challenges researchers face when using this methodology. ""Animal spirits""---i.e., revisions in beliefs about the state of the economy and its trajectory---have long been proposed as a potentially important source of business cycle fluctuations. The idea we investigate is whether macroeconomic data revisions provide a useful source of variation for evaluating the role of animal spirits in business cycles by generating noise in beliefs. We demonstrate that omitted variables bias and reverse causation imply that this approach is, unfortunately, uninformative in the business cycle context. Similar concerns arise when data revisions are used as shocks in other contexts.