Optimal trend inflation in an open economy

Abstract

We study the optimal inflation target in an open economy with a zero lower bound (ZLB) on nominal interest rates calibrated to the Euro area. When uncovered interest rate parity (UIP) holds, the optimal inflation target is smaller than in a closed economy. The key to this result is that real interest rates at the ZLB increase less as trade openness increases. This less pronounced increase in real interest rates in an open economy mitigates the contraction in aggregate demand, thus reducing the cost of ZLB. Additionally, the optimal inflation target in a monetary union is lower than in a flexible exchange rate regime: forming a monetary union results in a decrease in the optimal inflation rate by 0.24%, thereby increasing per-period welfare by 0.07%. When departures from UIP are significant, the optimal inflation target may be higher than in a closed economy, and the desirability of a monetary union increases further.