Should the ECB Adjust its Strategy in the Face of a Lower R*?

Abstract

We address this question using an estimated New Keynesian DSGE model of the Euro Area<br>with trend inflation, imperfect indexation, and a lower bound on the nominal interest rate. In<br>this setup, a decrease in the steady-state real interest rate, r*, increases the probability of<br>hitting the lower bound constraint, which entails significant welfare costs and warrants an<br>adjustment of the monetary policy strategy. Under an unchanged monetary policy rule, an<br>increase in the inflation target of eight tenth the size of the drop in the real natural rate of<br>interest is warranted. Absent an increase in the inflation target, and assuming the effective<br>lower bound prevents the ECB from implementing more aggressive negative interest rate<br>policies, adjusting the monetary strategy requires considering alternative instruments or<br>policy rules, such as committing to make-up for recent, below-target inflation realizations.5