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

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  • Andrés Blanco

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.

Suggested Citation

  • Andrés Blanco, 2021. "Optimal Inflation Target in an Economy with Menu Costs and a Zero Lower Bound," American Economic Journal: Macroeconomics, American Economic Association, vol. 13(3), pages 108-141, July.
    • Handle: RePEc:aea:aejmac:v:13:y:2021:i:3:p:108-41
    DOI: 10.1257/mac.20180198
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    References listed on IDEAS

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    12. Philippe Andrade & Jordi Gali & Herve Le Bihan & Julien Matheron, 2019. "The Optimal Inflation Target and the Natural Rate of Interest," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 50(2 (Fall)), pages 173-255.
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    Cited by:

    1. Naoko Hara & Yoshiyasu Ono, 2025. "Is the 2 Percent Inflation Target Sufficient? The Wealth Preference Approach," ISER Discussion Paper 1282, Institute of Social and Economic Research, The University of Osaka.
    2. Dobrew, Michael & Gerke, Rafael & Giesen, Sebastian & Röttger, Joost, 2025. "Make-up strategies with incomplete markets and bounded rationality," European Economic Review, Elsevier, vol. 173(C).
    3. Bianchi, Francesco & Melosi, Leonardo & Rottner, Matthias, 2021. "Hitting the elusive inflation target," Journal of Monetary Economics, Elsevier, vol. 124(C), pages 107-122.
    4. Stephen G. Hall, 2025. "An optimal inflation rate for South Africa," Economic Change and Restructuring, Springer, vol. 58(3), pages 1-29, June.
    5. Bryan P. Cutsinger & William J. Luther, 2025. "Symposium introduction: Reviewing the Federal Reserve's framework," Southern Economic Journal, John Wiley & Sons, vol. 91(4), pages 1213-1228, April.
    6. Mineyama, Tomohide, 2022. "Revisiting the optimal inflation rate with downward nominal wage rigidity: The role of heterogeneity," Journal of Economic Dynamics and Control, Elsevier, vol. 139(C).
    7. Volker Hahn, 2022. "Price Dispersion and the Costs of Inflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 54(2-3), pages 459-491, March.
    8. Francisca Sara-Zaror, 2024. "Inflation, Price Dispersion, and Welfare: The Role of Consumer Search," Finance and Economics Discussion Series 2024-047, Board of Governors of the Federal Reserve System (U.S.).
    9. DongIk Kang & Andrew Usher, 2023. "Does Product Revenue Matter for Price Setting and Monetary Policy Transmission?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 47, pages 297-345, January.
    10. Andrés Blanco & Andrés Drenik & Emilio Zaratiegui, 2025. "Nominal Devaluations, Inflation, and Inequality," American Economic Journal: Macroeconomics, American Economic Association, vol. 17(3), pages 270-310, July.
    11. Klaus Adam & Henning Weber, 2024. "The Optimal Inflation Target," CRC TR 224 Discussion Paper Series crctr224_2024_572, University of Bonn and University of Mannheim, Germany.
    12. Tomohide Mineyama, 2023. "Downward Nominal Wage Rigidity and Inflation Dynamics during and after the Great Recession," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 55(5), pages 1213-1244, August.
    13. S. Boragan Aruoba & Eugene Oue & Felipe Saffie & Jonathan L. Willis, 2023. "Real Rigidities, Firm Dynamics, and Monetary Nonneutrality: The Role of Demand Shocks," FRB Atlanta Working Paper 2023-03, Federal Reserve Bank of Atlanta.
    14. Karadi, Peter & Nakov, Anton & Nuño, Galo & Pasten, Ernesto & Thaler, Dominik, 2024. "Strike while the Iron is Hot: Optimal Monetary Policy with a Nonlinear Phillips Curve," CEPR Discussion Papers 19339, C.E.P.R. Discussion Papers.
    15. Miura, Shogo, 2023. "Optimal inflation rate and fair wage," The Quarterly Review of Economics and Finance, Elsevier, vol. 88(C), pages 158-167.
    16. Karadi, Peter & Nakov, Anton & Nuño, Galo & Pasten, Ernesto & Thaler, Dominik, 2025. "Strike while the iron is hot – optimal monetary policy under state-dependent pricing," Working Paper Series 3068, European Central Bank.
    17. Santoro, Sergio & Weber, Henning, 2023. "Micro price heterogeneity and optimal inflation," Occasional Paper Series 322, European Central Bank.
    18. Cho, Daeha & Kim, Jung Hyun & Kim, Kwang Hwan & Kim, Suk Joon, 2025. "Optimal trend inflation in an open economy," Journal of Monetary Economics, Elsevier, vol. 149(C).
    19. Lawrence H. White, 2025. "Should the Federal Reserve raise its inflation target?," Southern Economic Journal, John Wiley & Sons, vol. 91(4), pages 1372-1390, April.
    20. Andrés Blanco & Bernardo Diaz de Astarloa & Andres Drenik & Christian Moser & Danilo R. Trupkin, 2022. "The evolution of the earnings distribution in a volatile economy: Evidence from Argentina," Quantitative Economics, Econometric Society, vol. 13(4), pages 1361-1403, November.
    21. Abbritti, Mirko & Consolo, Agostino & Weber, Sebastian, 2021. "Endogenous growth, downward wage rigidity and optimal inflation," Working Paper Series 2635, European Central Bank.
    22. Kurozumi, Takushi & Van Zandweghe, Willem, 2024. "Output-inflation trade-offs and the optimal inflation rate," Journal of Economic Dynamics and Control, Elsevier, vol. 164(C).
    23. Adam, Klaus & Weber, Henning, 2024. "The Optimal Inflation Target: Bridging the Gap Between Theory and Policy," CEPR Discussion Papers 19170, C.E.P.R. Discussion Papers.

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    More about this item

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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