Higher inflation target of 3.5% reduces severity of recessions.
The optimal inflation target in an economy with menu costs and a zero lower bound on interest rates is 3.5 percent. This is higher than in commonly used models for monetary policy. Firm-level shocks play a key role in this result, as they reduce the impact of inflation on resource misallocation. A higher inflation target decreases price flexibility at the zero lower bound, which helps lessen the severity of recessions when the central bank is constrained.