Downward Nominal Wage Rigidity and Optimal Inflation Target

I investigate the welfare maximizing steady-state inflation rate in a heterogeneous-agent New Keynesian model with Downward Nominal Wage Rigidity (DNWR). After matching the annual wage change distribution in the U.S., I show that DNWR has a very significant impact on the economy when the inflation target is low. Considering the price dispersion due to sticky prices, zero lower bound, and declining trend productivity, I find that the optimal inflation target should be much higher than 2%, close to 7%, to mitigate the negative effects of DNWR on the labor market and to increase long-run welfare. This result holds taking transition dynamics into account and is robust to a wide range of parameterizations