Journal Article

The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise Their Inflation Targets in Light of the Zero Lower Bound?

Olivier Coibion, Yuriy Gorodnichenko and Johannes Wieland

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 79, issue 4, pages 1371-1406
Published in print October 2012 | ISSN: 0034-6527
Published online March 2012 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1093/restud/rds013
The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise Their Inflation Targets in Light of the Zero Lower Bound?

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  • Prices, Business Fluctuations, and Cycles
  • Monetary Policy, Central Banking, and the Supply of Money and Credit
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We study the effects of positive steady-state inflation in New Keynesian models subject to the zero bound on interest rates. We derive the utility-based welfare loss function taking into account the effects of positive steady-state inflation and solve for the optimal level of inflation in the model. For plausible calibrations with costly but infrequent episodes at the zero lower bound, the optimal inflation rate is low, typically <2% even after considering a variety of extensions, including optimal stabilization policy, price indexation, endogenous and state-dependent price stickiness, capital formation, model uncertainty, and downward nominal wage rigidities. On the normative side, price-level targeting delivers large welfare gains and a very low optimal inflation rate consistent with price stability. These results suggest that raising the inflation target is too blunt an instrument to efficiently reduce the severe costs of zero bound episodes.

Keywords: Optimal inflation; New Keynesian; Zero bound; Price-level targeting; E3; E4; E5

Journal Article.  16772 words.  Illustrated.

Subjects: Prices, Business Fluctuations, and Cycles ; Monetary Policy, Central Banking, and the Supply of Money and Credit ; Money and Interest Rates

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