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

Abstract

I study the optimal inflation target in a quantitative menu cost model with a zero lower bound on interest rates. I find that the optimal inflation target is 3.5 percent, which is higher than in models commonly used for monetary policy analysis. Key to this result is that inflation has a small effect on resource misallocation when the model features firm-level shocks, which are necessary to match the empirical distribution of price changes. A higher inflation target decreases price flexibility at the zero lower bound, and through this mechanism, it reduces the severity of recessions when the monetary authority is constrained. (JEL E12, E31, E32, E42, E52)