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Optimal monetary policy with staggered wage and price contracts

  • Christopher J. Erceg
  • Dale W. Henderson
  • Andrew T. Levin

We formulate an optimizing-agent model in which both labor and product markets exhibit monopolistic competition and staggered nominal contracts. The unconditional expectation of average household utility can be expressed in terms of the unconditional variances of the output gap, price inflation, and wage inflation. Monetary policy cannot replicate the Pareto-optimal equilibrium that would occur under completely flexible wages and prices; that is, the model exhibits a tradeoff between stabilizing the output gap, price inflation, and wage inflation. The Pareto optimum is attainable only if either wages or prices are completely flexible. For reasonable calibrations of the model, we characterize the optimal policy rule. Furthermore, strict price inflation targeting is clearly suboptimal, whereas rules that also respond to either the output gap or wage inflation are nearly optimal.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 640.

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Date of creation: 1999
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Handle: RePEc:fip:fedgif:640
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