Discussion Paper

No. 2017-64 | September 25, 2017
Optimal inflation target: insights from an agent-based model


Which level of inflation should Central Banks be targeting? The authors 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 micro-behaviour of agents (in particular inflation anticipations), they find a surprisingly rich variety of behaviour at the macro-level. Without any monetary policy, our ABM economy can be in a high inflation/high output state, or in a low inflation/low output state. Hyper-inflation, stagflation, deflation and business cycles are also possible. The authors then introduce a Central Bank with a Taylor-rule-based inflation target, and study the resulting aggregate variables. The main result is that too low inflation targets are in general detrimental to a CB-controlled economy. One symptom is a persistent under-realisation of inflation, perhaps similar to the current macroeconomic situation. This predicament is alleviated by higher inflation targets that are found to improve both unemployment and negative interest rate episodes, up to the point where erosion of savings becomes unacceptable. The results are contrasted with the predictions of the standard DSGE model.

JEL Classification:

E31, E32, E52


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Cite As

Jean-Philippe Bouchaud, Stanislao Gualdi, Marco Tarzia, and Francesco Zamponi (2017). Optimal inflation target: insights from an agent-based model. Economics Discussion Papers, No 2017-64, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2017-64

Comments and Questions

Anonymous - Invited assessment
October 19, 2017 - 00:34

The authors use an Agent-Based Model to investigate the optimal level of inflation that a Central Bank should target. Their ABM is mainly populated by firms that produce, set prices and wages and hire workers. Other agents are a Central Bank determining baseline interest rates, a representative private bank setting ...[more]

... the interest rates on deposits and loans and a representative household that decides on the level of consumption given their expectations on inflation. The behavioral rules that determine the decisions of the agents are based on economic intuition – prices adjust to accommodate demand, firms hire workers and increase wages if they are not financially fragile, etc. The authors show that targeting a higher than 2% level of inflation reduces unemployment and the probability of negative nominal interest rates. This result is at odds with the prediction of a DSGE model specifically thought to address the same question of optimality of inflation targeting.

This is an important question that has not yet been studied within the ABM literature. (I would also suggest to the authors to look at the paper “Animal spirits and monetary policy” by Paul De Grauwe). The paper is methodologically sound, and the authors rightly acknowledge all limitations of their model. In addition to the weaknesses they mention, I would add that the behavioral rules are sometimes too rigid, and this can lead to unreasonable outcomes like 100% unemployment. The paper is generally well written, although minor revisions might improve readability (see below). One thing I did not understand is the negative real interest rate on deposits in Fig.3(d). First, it does not look reasonable that in the baseline parametrization interest rates are negative. Second, inflation targeting at 2% is actually better than at 3-5% in this case. Another thing the paper falls short is providing clear intuition in what drives some results, although this may be unavoidable in ABMs. For example, what drives the piebald phase diagram in Figure 2? Or the non-monotonicity in Fig. 4(a)?

Most importantly, I really like the idea of a neck and neck comparison with a DSGE model, for instance modelling consumption similarly (euler equation). As a main comment, I would suggest pushing this comparison even further. For example, can the results in Fig. 3(a) and 4(a) be compared with the New Keynesian Phillips Curve? Is the assumption that all firms produce a different good comparable to the Dixit-Stiglitz monopolistic competition? Is it possible to clearly identify a transmission mechanism that is absent in DSGE models? The reply to this paper from mainstream economists would be: nice to know that all these results are possible, but what have I learned from that in terms of economic intuition? Sorry to be vague on this last point.

Minor revisions:
- I would replace \ro by r, as is standard in the literature
- I would not use the acronyms HIHO and HILO in the captions or subsection headings
- Figures 1-2-5-6-7 should have larger axis and tick labels, bigger color bar and more explicative color bar title (e.g. unemployment and not <u>).
- I would replace “the authors” by “we” in the abstract