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

  • Yuriy Gorodnichenko

    (UC Berkeley)

  • Johannes Wieland

    (University of California, Berkeley)

  • Olivier Coibion

    (College of William and Mary)

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 less than two percent, 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.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 70.

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Date of creation: 2012
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Handle: RePEc:red:sed012:70
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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