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Optimal Monetary Policy with Staggered Wage and Price Contracts

01 Mar 1999-Research Papers in Economics (Board of Governors of the Federal Reserve System (U.S.))-
TL;DR: In this article, the unconditional expectation of average household utility is expressed in terms of the unconditional variances of the output gap, price inflation, and wage inflation, where the model exhibits a tradeoff between stabilizing output gap and price inflation.
Abstract: 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.
Citations
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Journal ArticleDOI
TL;DR: Using a Bayesian likelihood approach, the authors estimate a dynamic stochastic general equilibrium model for the US economy using seven macroeconomic time series, incorporating many types of real and nominal frictions and seven types of structural shocks.
Abstract: Using a Bayesian likelihood approach, we estimate a dynamic stochastic general equilibrium model for the US economy using seven macro-economic time series. The model incorporates many types of real and nominal frictions and seven types of structural shocks. We show that this model is able to compete with Bayesian Vector Autoregression models in out-of-sample prediction. We investigate the relative empirical importance of the various frictions. Finally, using the estimated model we address a number of key issues in business cycle analysis: What are the sources of business cycle fluctuations? Can the model explain the cross-correlation between output and inflation? What are the effects of productivity on hours worked? What are the sources of the "Great Moderation"?

3,155 citations

01 Jan 2002

2,821 citations


Cites background from "Optimal Monetary Policy with Stagge..."

  • ...In such circumstances, complete price stability may not be a good approximation at all to the optimal policy, as Erceg et al. (1999) show....

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01 Oct 2002
TL;DR: In this article, a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area was developed and estimated with Bayesian techniques using seven key macroeconomic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate.
Abstract: This paper develops and estimates a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilisation. It is estimated with Bayesian techniques using seven key macro-economic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate. The introduction of ten orthogonal structural shocks (including productivity, labour supply, investment, preference, cost-push and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle fluctuations in the euro area. Using the estimated model, the paper also analyses the output (real interest rate) gap, defined as the difference between the actual and model-based potential output (real interest rate).

2,716 citations


Cites background or methods from "Optimal Monetary Policy with Stagge..."

  • ...In this paper we present and estimate a dynamic stochastic general equilibrium (DSGE) model for the euro area....

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  • ...Following Kollmann (1997) and Erceg, Henderson, and Levin (2000), we assume that wages can only be optimally adjusted after some random “wage-change signal” is received....

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  • ...Erceg, Henderson, and Levin (2000) use indexation to the average steady-state in ation rate....

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  • ...However, Erceg, Henderson, and Levin (2000) have shown that in this case targeting a weighted average of price in ation and the output gap, de ned as the deviation of actual output from its exible price level, comes close to optimal monetary policy....

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  • ...A closed economy version is analyzed in Erceg, Henderson, and Levin (2000)....

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Posted Content
TL;DR: The authors present a model embodying moderate amounts of nominal rigidities which accounts for the observed inertia in inflation and persistence in output, and the key features of their model are those that prevent a sharp rise in marginal costs after an expansionary shock to monetary policy.
Abstract: We present a model embodying moderate amounts of nominal rigidities which accounts for the observed inertia in inflation and persistence in output. The key features of our model are those that prevent a sharp rise in marginal costs after an expansionary shock to monetary policy. Of these features, the most important are staggered wage contracts of average duration three quarters, and variable capital utilization.

2,580 citations

Book
27 Oct 1998
TL;DR: In this article, empirical evidence on money and output is presented, including the Tobin effect and the MIU approximation problems, and a general equilibrium framework for monetary analysis is presented.
Abstract: Part 1 Empirical evidence on money and output: introduction some basic correlations estimating the effect of money on output summary. Part 2 Money in a general equilibrium framework: introduction the Tobin effect money in the utility function summary appendix - the MIU approximation problems. Part 3 Money and transactions: introduction shopping-time models cash-in-advance models other approaches summary appendix - the CIA approximation problems. Part 4 Money and public finance: introduction bugdet accounting equilibrium seigniorage optimal taxation and seigniorage Friedman's rule revisited nonindexed tax systems problems. Part 5 Money and output in the short run: introduction flexible prices sticky prices and wages a framework for monetary analysis inflation persistence summary appendix problems. Part 6 Money and the open economy: introduction the Obstfeld-Rogoff two-country model policy coordination the small open economy summary appendix problems. Part 7 The credit channel of monetary policy: introduction imperfect information in credit markets macroeconomic implications does credit matter? summary. Part 8 Discretionary policy and time inconsistency: introduction inflation under discretionary policy solutions to the inflation bias is the inflation bias important? do central banking institutions matter? lessons and conclusions problems. Part 9 Monetary-policy operating procedures: introduction from instruments to goals the instrument-choice problem operating procedures and policy measures problems. Part 10 Interest rates and monetary policy: introduction interest-rate rule and the price level interest rate policies in general equilibrium models the term structure of interest rates a model for policy analysis summary problems.

2,049 citations

References
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Journal ArticleDOI
TL;DR: In this article, the authors developed a model of staggered prices along the lines of Phelps (1978) and Taylor (1979, 1980), but utilizing an analytically more tractable price-setting technology.

8,580 citations

Journal ArticleDOI
TL;DR: In this article, the authors examine how recent econometric policy evaluation research on monetary policy rules can be applied in a practical policymaking environment, and the discussion centers around a hypothetical but representative policy rule much like that advocated in recent research.

8,414 citations

Journal ArticleDOI
TL;DR: In this article, an explicit solution for an important subclass of the model Shiller refers to as the general linear difference model is given, together with the conditions for existence and uniqueness.
Abstract: IN HIS SURVEY ON RATIONAL EXPECTATIONS, R. Shiller indicates that the difficulty of obtaining explicit solutions for linear difference models under rational expectations may have hindered their use [14, p. 27]. The present paper attempts to remedy that problem by giving the explicit solution for an important subclass of the model Shiller refers to as the general linear difference model. Section 1 presents the form of the model for which the solution is derived and shows how particular models can be put in this form. Section 2 gives the solution together with the conditions for existence and uniqueness. 1. THE MODEL The model is given by (la), (lb), and (1c) as follows:

2,536 citations

Journal ArticleDOI
TL;DR: In this article, the authors show that staggered wage contracts as short as 1 year are capable of generating the type of unemployment persistence which has been observed during postwar business cycles in the United States.
Abstract: Staggered wage contracts as short as 1 year are shown to be capable of generating the type of unemployment persistence which has been observed during postwar business cycles in the United States. A...

2,525 citations

Journal ArticleDOI
TL;DR: In this paper, a simple quantitative model of output, interest rate and inflation determination in the United States, and uses it to evaluate alternative rules by which the Fed may set interest rates.
Abstract: This paper considers a simple quantitative model of output, interest rate and inflation determination in the United States, and uses it to evaluate alternative rules by which the Fed may set interest rates. The model is derived from optimizing behavior under rational expectations, both on the part of the purchasers of goods (who choose quantities to purchase given the expected path of real interest rates), and upon that of the sellers of goods (who set prices on the basis of the expected evolution of demand). Numerical parameter values are obtained in part by seeking to match the actual responses of the economy to a monetary shock to the responses predicted by the model. The resulting model matches the empirical responses quite well and, once due account is taken of its structural disturbances, can account for our data nearly as well as an unrestricted VAR. The monetary policy rule that most reduces inflation variability (and is best on this account) requires very variable interest rates, which in turn is...

2,210 citations