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

Abstract

Countries rarely hit the zero lower bound (ZLB) on interest rates, but when they do, these episodes tend to be very long-lived. These two features are difficult to incorporate jointly 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.