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How does a higher inflation target help to reduce the risk to a central bank of...

How does a higher inflation target help to reduce the risk to a central bank of hitting the ZLB? (Hint: Use the Fisher effect.)

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Answer #1

According to Fisher equation ,

real interest rate = nominal interest rate - rate of inflation.

Or, nominal interest rate = real interest rate + rate of inflation.

By quantity theory of money percentage change in money supply leads to same percentage change in inflation. If central bank increases money supply then inflation will be higher. From Fisher's equation higher inflation means higher nominal interest rate and this reduces the risk of the hitting the Zero Lower Bound (ZLB) of interest rate.

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