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

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