The Risk of Hitting the Zero Lower Bound and the Optimal Inflation Target

Based on the US interest rates data, I estimate that the risk for the nominal interest rate to hit the zero lower bound (ZLB) is around 16% in the US if the Fed continues to keep the inflation target at 2%. I then develop a small dynamic stochastic general equilibrium model featuring an occasionally binding ZLB, and calibrate the model to match with the risk. Solving the model using a fully nonlinear method, I find that the optimal inflation target is around 3:5%. In addition, the optimal inflation target is sensitive to both the risk of hitting the ZLB and the degree of inflation indexation.