UC Berkeley

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.