Long‐Run Inflation and the Distorting Effects of Sticky Wages and Technical Change

We show that the Calvo price‐setting model is not necessarily inconsistent with evidence of a weak relation between positive trend inflation and price dispersion. We identify the interaction between sticky wages and technical change as factors disrupting the allocative role of the wage system under positive trend inflation. In turn, this interaction generates inefficient wage dispersion, as opposed to price dispersion, which fuels inflation costs. We conclude that it is too early to dismiss the New Keynesian model as a useful vehicle to assess the costs of inflation.     

Optimal fiscal and monetary policy with sticky prices

In this paper I consider the role of state-contingent inflation as a fiscal shock absorber in an economy with nominal rigidities. I study the Ramsey equilibrium in a monetary model with distortionary taxation, nominal non-state-contingent debt, and sticky prices. With sticky prices, the Ramsey planner must balance the shock absorbing benefits of state-contingent inflation against the associated resource misallocation costs. For government spending processes resembling post-war experience, introducing sticky prices generates striking departures in optimal policy from the case with flexible prices. For even small degrees of price rigidity, optimal policy displays very little volatility in inflation. Tax rates display greater volatility compared to the model with flexible prices. With sticky prices, tax rates and real government debt exhibit behavior similar to a random walk. For government spending processes resembling periods of intermittent war and peace, optimal policy displays extreme inflation volatility even when the degree of price rigidity is large. As the variability in government spending increases, smoothing tax distortions across states of nature becomes increasingly important, and the shock absorber role of inflation is accentuated.     

Technology Shocks and Monetary Policy: Revisiting the Fed's Performance

Would the U.S. economy's dynamic response to permanent technology shocks have been different from the actual responses if monetary authorities' systematic response to these shocks had been optimal? To answer this question, we characterize the dynamic effects of permanent technology shocks and the way in which U.S. monetary authorities reacted to these shocks over the sample 1955(1)–2002(4) using a structural VAR. A sticky price–sticky wage model is developed and estimated to reproduce these responses. We then formally compare these responses with the outcome of the optimal monetary policy.     

The Quantitative Importance of News Shocks in Estimated DSGE Models

We estimate a dynamic stochastic general equilibrium (DSGE) model with several frictions and both unanticipated and news shocks, using quarterly U.S. data from 1954 to 2004 and Bayesian methods. We find that unanticipated shocks dominate news shocks in accounting for the unconditional variance of output, consumption, and investment growth, interest rate, and the relative price of investment. The unanticipated shock to the marginal efficiency of investment is the dominant shock, accounting for over 45% of the variance in output growth. News shocks account for less than 15% of the variance in output growth. Within the set of news shocks, nontechnology sources of news dominate technology news, with wage markup news shocks accounting for about 60% of the variance share of both hours and inflation. We find that in the estimated DSGE model (i) the presence of endogenous countercyclical price and wage markups due to nominal frictions substantially diminishes the importance of news shocks relative to a model without these frictions, and (ii) while there is little change in the estimated contributions of technology news when we restrict wealth effects on labor supply, the contributions of nontechnology news shocks are relatively more sensitive.     

Inflation Dynamics When Inflation Is Near Zero

We discuss the likely evolution of U.S. inflation in the near and medium terms on the basis of (i) past U.S. experience with very low levels of inflation, (ii) the most recent Japanese experience with negative inflation, and (iii) some preliminary U.S. micro evidence on downward nominal wage rigidity. Our findings question the view that stable long‐run inflation expectations and downward nominal wage rigidity will necessarily provide sufficient support to prices to avoid further declines in inflation. We show that an inflation model fitted on Japanese data over the past 20 years, which accounts for both short‐ and long‐run inflation expectations, matches the recent U.S. inflation experience quite well. While the model indicates that U.S. inflation might be subject to a lower bound, it does not rule out a prolonged period of low inflation or even mild deflation going forward. In addition, micro‐level data on wages suggest no obvious downward rigidity in the firm's wage bill, downward rigidity in individual wages notwithstanding. As a consequence, downward nominal wage rigidity may not be enough to offset deflationary pressures in the current situation.     

The Passthrough of Labor Costs to Price Inflation

We use a time‐varying parameter/stochastic volatility VAR framework to assess how the passthrough of labor costs to price inflation has evolved over time in U.S. data. We find little evidence that independent movements in labor costs have had a material effect on price inflation in recent years, even for compensation measures where some degree of passthrough to prices still appears to be present. Our results cast doubt on explanations of recent inflation behavior that appeal to such mechanisms as downward nominal wage rigidity or a differential contribution of long‐term and short‐term unemployed workers to wage and price pressures.     

Optimal monetary policy in a small open economy with staggered wage and price contracts

We study optimal monetary policy for a small open economy in a model where both domestic prices and wages are sticky due to staggered contracts. The simultaneous presence of the two forms of nominal rigidities introduces an additional trade-off between domestic inflation and the output gap. We derive a second-order approximation to the average welfare losses that can be expressed in terms of the unconditional variances of the output gap, domestic price inflation, and wage inflation. As a consequence, the optimal policy seeks to minimize a weighted average of these variances. We analyze welfare implications of several alternative simple policy rules, and find that domestic price inflation targeting generates relatively large welfare losses, whereas CPI inflation targeting performs nearly as well as the optimal rule.     

Optimal monetary policy with durable consumption goods

We document that the durable goods sector is much more interest-sensitive than the nondurables sector, and then investigate the implications of these sectoral differences for monetary policy. We formulate a two-sector general equilibrium model that is calibrated both to match the sectoral responses to a monetary shock derived from our empirical VAR and to imply an empirically realistic degree of sectoral output volatility and comovement. While the social welfare function involves sector-specific output gaps and inflation rates, the performance of the optimal policy rule can be closely approximated by a simple rule that targets a weighted average of aggregate wage and price inflation. In contrast, a rule that stabilizes a more narrow measure of final goods price inflation performs poorly in terms of social welfare.     

Robustness and real consequences of nominal wage rigidity

Nominal wage rigidity has been shown to exist in periods of high inflation, while reduction in nominal pay has been hypothesized to occur in times of low inflation. Nominal wage rigidity would therefore become irrelevant because there is little need to cut nominal pay under high inflation, while the necessary cuts would occur under low inflation. We test this hypothesis by examining Swiss data in the 1990s, where wage inflation was low. Nominal wage rigidity proves robust in a low inflation environment, constituting a considerable obstacle to real wage adjustments. Real wages would indeed respond to unemployment without downward nominal rigidity. Moreover, wage sweep-ups caused by nominal rigidity correlate strongly to unemployment, suggesting downward nominal wage rigidity fuels unemployment.     

Monetary News Shocks

We pursue an empirical strategy to identify a monetary news shock in the U.S. economy. We use a monetary policy residual, along with other variables in a vector autoregression (VAR), and identify a monetary news shock as the linear combination of reduced-form innovations that is orthogonal to the current residual and that maximizes the sum of contributions to its forecast error variance over a finite horizon. Real GDP declines in a persistent manner after a positive monetary news shock. This contraction in economic activity is accompanied by a fall in inflation and a rapid increase in the nominal interest rate.     

What do technology shocks tell us about the New Keynesian paradigm?

Researchers have used unanticipated changes to monetary policy to identify preference and technology parameters of macroeconomic models. This paper uses changes in technology to identify the same set of parameters. Estimates based on technology shocks differ substantially from those based on monetary policy shocks. In the post-World War II United States, a positive technology shock reduces inflation and increases hours worked, significantly and rapidly in both cases. Relative to policy shock identification, technology shock identification implies: (i) long duration durability in preferences instead of short duration habit, (ii) built-in inflation inertia disappears and price flexibility increases. In response to technological improvement, consumption durability increases hours worked because households temporarily increase labor supply to accumulate durables towards a new, higher steady state level. Limited nominal rigidities allow inflation to fall because firms are able to immediately cut prices when households’ labor supply increases. Finally, we consider alternative data constructions and econometric specifications; we find that (i) and/or (ii) hold in nearly every case.     

Sticky Price Models,Durable Goods,and Real Wage Rigidities

The standard two‐sector New Keynesian model with durable goods is at odds with conventional wisdom and vector autoregression (VAR) evidence: Following a monetary shock, the model generates (i) either negative or no comovement across sectoral outputs and (ii) aggregate neutrality of money when durable goods' prices are flexible. We reconcile theory with evidence by incorporating real wage rigidities into the standard model: As long as durable goods' prices are more flexible than nondurable goods' prices, we obtain positive sectoral comovement and, thus, aggregate nonneutrality of money.     

Optimal Monetary Policy with Labor Market Frictions: The Role of the Wage Channel

This paper introduces right‐to‐manage bargaining into a labor search model with sticky prices instead of standard efficient bargaining and examines the Ramsey‐optimal monetary policy. Without real wage rigidity, even when the steady state is inefficient, price stability is nearly optimal in response to technology or government shocks. Right‐to‐manage bargaining creates the wage channel to inflation, because there is a direct relationship between real wages and real marginal cost. In the presence of the wage channel, price markups consist of only real marginal cost, and real wages and hours per worker are determined such as in the Walrasian labor market.     

Trend inflation, wage and price rigidities, and productivity growth

What are the steady-state implications of inflation in a general-equilibrium model with real per capita output growth and staggered nominal price and wage contracts? Surprisingly, a benchmark calibration implies an optimal inflation rate of -1.9 percent. The analysis also shows that trend inflation has important effects on the economy when combined with nominal contracts and real output growth. Steady-state output and welfare losses are quantitatively important even for low values of trend inflation. Further, nominal wage contracting is found to be quantitatively more important than nominal price contracting in generating the results. This conclusion does not arise from price dispersion per se, but from an effect of nominal output growth on the optimal markup of monopolistically competitive labour suppliers. Finally, accounting for productivity growth is found to be important for calculating the welfare costs of inflation. Indeed, the presence of 2 percent productivity growth increases the welfare costs of inflation in the benchmark specification by a factor of four relative to the no-growth case.     

Raise Rates to Raise Inflation? Neo‐Fisherianism in the New Keynesian Model

Increasing the inflation target in a New Keynesian (NK) model may require increasing, rather than decreasing, the nominal interest rate in the short run. We refer to this positive short‐run comovement between the nominal rates and inflation conditional on a nominal shock as Neo‐Fisherianism. We show that the NK model is more likely to be Neo‐Fisherian the more persistent is the change in the inflation target and the more flexible are prices. Neo‐Fisherianism is driven by the forward‐looking nature of the model. Modifications that make the framework less forward‐looking make it less likely for the model to exhibit Neo‐Fisherianism.     

Uncertainty shocks are aggregate demand shocks

Search frictions in the labor market give rise to a new option-value channel through which uncertainty affects aggregate economic activity, and the effects of which are reinforced by the presence of nominal rigidities. With these features, an increase in uncertainty resembles an aggregate demand shock because it increases unemployment and lowers inflation. Using a new empirical measure of uncertainty based on the Michigan survey and a VAR model, we show that these theoretical patterns are consistent with US data. Using a calibrated DSGE model, we show that combining search frictions and nominal rigidities can match the qualitative VAR pattern and account for about 70 percent of the empirical increase in unemployment following an uncertainty shock.     

Downward Nominal Wage Rigidities Bend the Phillips Curve

We introduce a model of monetary policy with downward nominal wage rigidities and show that both the slope and curvature of the Phillips curve depend on the level of inflation and the extent of downward nominal wage rigidities. This is true for the both the long‐run and the short‐run Phillips curve. Comparing simulation results from the model with data on U.S. wage patterns, we show that downward nominal wage rigidities likely have played a role in shaping the dynamics of unemployment and wage growth during the last three recessions and subsequent recoveries.     

Time-dependent or state-dependent wage-setting? Evidence from periods of macroeconomic instability

Administrative data on monthly wages in Iceland during 1998–2010 provide new insight into nominal wage rigidity. Unlike the data used in previous work, ours have a higher frequency, minimal measurement error, and a long sample including a period of substantial macroeconomic instability. We find that the monthly frequency of nominal wage changes is 13 percent. Although nominal wage cuts are rare, their frequency rises following a large macroeconomic shock. Timing of wage changes is both time-dependent and state-dependent: we find evidence of synchronization of adjustment and contracts of fixed duration, but also that inflation and unemployment over the wage spell affect the timing of adjustment.     

Equilibrium Unemployment, Job Flows, and Inflation Dynamics

In order to explain the joint fluctuations of output, inflation and the labor market, this paper develops and estimates a general equilibrium model that integrates a theory of equilibrium unemployment into a monetary model with nominal price rigidities. The estimated model accounts for the responses of employment, hours per worker, job creation, and job destruction to a monetary policy shock. Moreover, search frictions in the labor market generate a lower elasticity of marginal costs with respect to output. This helps to explain the sluggishness of inflation and the persistence of output that are observed in the data.     

In search of the liquidity effect in a modern monetary model

This paper examines the impact of a monetary policy shock in a dynamic stochastic general equilibrium model with sticky prices and financial market frictions. First, we examine the shortcomings of monetary models emphasizing these frictions individually. The model then is specified to limit the response of prices and savings to a current period monetary disturbance. Our results show that this model can account for the following key responses to an expansionary monetary policy shock: a fall in the nominal interest rate; a rise in output, consumption, and investment; and a gradual increase in the price level. Finally, a detailed sensitivity analysis shows the model's results depend on the parameters assigned to critical structural features.