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THE RISK OF HITTING THE ZERO LOWER BOUND AND THE OPTIMAL INFLATION TARGET

Published online by Cambridge University Press:  02 May 2017

Phuong V. Ngo
Phuong V. Ngo*
Affiliation:
Cleveland State University
*
Address correspondence to: Phuong V. Ngo, Department of Economics, Cleveland State University, 2121 Euclid, RT 1705, Cleveland, OH 44115, USA; e-mail: p.ngo@csuohio.edu.
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Abstract

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I examine the optimal inflation target in a dynamic stochastic New Keynesian model featuring an occasionally binding zero lower bound on nominal interest rate (ZLB). To this end, I first calibrate the shock needed to generate the risk of hitting the ZLB that matches the U.S. data, based on a fully nonlinear method. I then resolve the model with different inflation targets and find that the optimal target is 3.4%. In addition, the optimal inflation target is a nonlinear function of the risk of hitting the ZLB and inflation indexation. It is always greater than 2% if the risk is greater than 2.5% or if the inflation indexation is higher than 0.5. Finally, the linear–quadratic approach overestimates the true optimal inflation target. In particular, based on the benchmark calibration, it generates an optimal target of 5.5%, compared with 3.4% found by the fully nonlinear method.

Keywords

Zero Lower BoundOptimal Inflation TargetInflation IndexationRotemberg Price Adjustments

Information

Type
Articles
Information
Macroeconomic Dynamics , Volume 22 , Issue 2 , March 2018, pp. 402 - 425
Copyright
Copyright © Cambridge University Press 2017 

Footnotes

I am grateful to Jianjun Miao for his advice and encouragement and to Tai Nakata and Nathaniel Throckmorton for very helpful conversations. I have also benefited from excellent comments and suggestions by two anonymous reviewers. In addition, I thank the participants at the Spring 2015 Midwest Marco Meeting for valuable comments.

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