Optimal Inflation Target in an Economy with Menu Costs and Zero Lower Bound

Andrés Blanco

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2017-02-15 - This paper studies the optimal inflation target in a medium-scale menu cost model with an occasionally binding zero lower bound on interest rates. I find that the optimal inflation target is 3%, larger than the rates currently targeted by the Fed and the ECB, and also larger than in existing models used for monetary policy analysis. When my model is consistent with the frequency and the distribution of price changes, resource misallocation does not increase greatly with inflation. The key element for this result is firms’ idiosyncratic shocks, which is necessary to match the micro data. Inflation is therefore not as costly as in existing models, even though my model’s business cycle implications are similar to the ones found in those models (e.g. Calvo) in normal times. For this reason, a higher inflation target, aimed at reducing the frequency and severity of recessions caused by the zero lower bound, is warranted.