Infrequent But Long-Lived Zero-Bound Episodes and the Optimal Rate of Inflation

Abstract

Countries rarely hit the zero-lower bound on interest rates, but when they do, these episodes tend to be very long-lived. These two features are difficult to jointly incorporate into macroeconomic models using typical representations of shock processes. We introduce a regime switching representation of risk premium shocks into an otherwise standard New Keynesian model to generate a realistic distribution of ZLB durations. We discuss what different calibrations of this model imply for optimal inflation rates.