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Endogenous growth, downward wage rigidity and optimal inflation

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  • Abbritti, Mirko
  • Consolo, Agostino
  • Weber, Sebastian

Abstract

Standard New Keynesian (NK) models feature an optimal inflation target well below two percent, limited welfare losses from business cycle fluctuations and long-term monetary neutrality. We develop a NK framework with labour market frictions, endogenous productivity and downward wage rigidity (DWR) which challenges these results. The model features a non-vertical long-run Phillips curve between inflation and unemployment and a trade-off between price distortions and output hysteresis that change the welfare-maximizing inflation level. For a plausible set of parameters, the optimal inflation target is in excess of two percent, a target value commonly used across central banks. Deviations from the optimal target carry welfare costs multiple times higher than in traditional NK models. The main reason is that endogenous growth and DWR generate asymmetric and hysteresis effects on unemployment and output. Price level targeting or a Taylor-rule responding to the unemployment rate can handle better the asymmetric and hysteresis effects in our model and deliver significant welfare gains. Our results are robust to the inclusion of the effective lower bound on the monetary policy interest rate. JEL Classification: E24, E3, E5, O41, J64

Suggested Citation

  • Abbritti, Mirko & Consolo, Agostino & Weber, Sebastian, 2021. "Endogenous growth, downward wage rigidity and optimal inflation," Working Paper Series 2635, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20212635
    Note: 3572376
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    References listed on IDEAS

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    More about this item

    Keywords

    downward wage rigidity; endogenous growth; monetary policy; monetary policy invariance hypothesis; optimal inflation target; zero lower bound;
    All these keywords.

    JEL classification:

    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models
    • J64 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment: Models, Duration, Incidence, and Job Search

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