Working Paper Series no. 243: Inflation Target Shocks and Monetary Policy Inertia in the Euro Area

Abstract

The Euro area as a whole has experienced a marked downward trend in inflation over the past decades and, concomitantly, a protracted period of depressed activity. Can permanent and gradual shifts in monetary policy be held responsible for these dynamics? To answer this question, we embed serially correlated changes in the inflation target into a DSGE model with real and nominal frictions. The formal Bayesian estimation of the model suggests that gradual changes in the inflation target have played a major role in the Euro area business cycle. Following an inflation target shock, the real interest rate increases sharply and persistently, leading to a protracted decline in economic activity. Counter--factual exercises show that, had monetary policy implemented its new inflation objective at a faster rate, the Euro zone would have experienced more sustained growth than it actually did.

Patrick Fève, Julien Matheron and Jean-Guillaume Sahuc
August 2009

Classification JEL : E31, E32, E52.

Keywords : inflation target shocks, gradualism, DSGE models, Bayesian econometrics.