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Erceg, C., Henderson, D., Levin, A. Optimal Monetary Policy with Staggered Wage and Price Contracts. Credit and Capital Markets – Kredit und Kapital, 52(4), 537-571. https://doi.org/10.3790/ccm.52.4.537
Erceg, Christopher J.; Henderson, Dale W. and Levin, Andrew T.. "Optimal Monetary Policy with Staggered Wage and Price Contracts" Credit and Capital Markets – Kredit und Kapital 52.4, 2019, 537-571. https://doi.org/10.3790/ccm.52.4.537
Erceg, Christopher J./Henderson, Dale W./Levin, Andrew T. (2019): Optimal Monetary Policy with Staggered Wage and Price Contracts, in: Credit and Capital Markets – Kredit und Kapital, vol. 52, iss. 4, 537-571, [online] https://doi.org/10.3790/ccm.52.4.537

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Optimal Monetary Policy with Staggered Wage and Price Contracts

Erceg, Christopher J. | Henderson, Dale W. | Levin, Andrew T.

Credit and Capital Markets – Kredit und Kapital, Vol. 52 (2019), Iss. 4 : pp. 537–571

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Article Details

Author Details

Prof. Dr. Christopher J. Erceg, National Bureau of Economic Research, Federal Reserve Board, 1050 Massachusetts Ave, Cambridge, MA 02138, USA

Prof. Dr. Dale W. Henderson, Georgetown University, General Economics, 3700 O St NW, Washington, DC 20057, USA

Prof. Dr. Andrew T. Levin. Dartmouth College, Department of Economics, 322 Rockefeller Hall, Hanover, NH 03755–3514, USA

References

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  2. Anderson, G. S./Moore, G. (1985): A linear algebraic procedure for solving linear perfect foresight models. Economic Letters 17, pp. 247–252.  Google Scholar
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  6. Blanchard, O. J./Kiyotaki, N. (1987): Monopolistic competition and the effects of aggregate demand. American Economic Review 77 (4), pp. 647–666.  Google Scholar
  7. Bryant, R./Hooper, P./Mann, Z. C. (1993): Evaluating Policy Regimes: New Research in Empirical Macroeconomics. Brookings Institution, Washington, D.C.  Google Scholar
  8. Calvo, G. (1983): Staggered prices in a utility maximizing framework. Journal of Monetary Economics 12, pp. 383–398.  Google Scholar
  9. Canzoneri, M. B. (1980): Labor contracts and monetary policy. Journal of Monetary Economics 6, pp. 241–245.  Google Scholar
  10. Cuddington, J. T./Johansson, P.-O./Löfgren, K.-G. (1984): Disequilibrium Macroeconomics in Open Economies. Basil Blackwell, Oxford.  Google Scholar
  11. Dixit, A. K./Stiglitz, J. (1977): Monopolistic competition and optimum product diversity. American Economic Review 67, pp. 297–308.  Google Scholar
  12. Dotsey, M./King, R. G./Wolman, A. L. (1997): State dependent pricing and dynamics of business cycles. Working paper No. 97-2, Federal Reserve Bank of Richmond.  Google Scholar
  13. Erceg, C. J. (1997): Nominal wage rigidities and the propagation of monetary disturbances. International Finance Discussion Papers, No. 590, Federal Reserve Board.  Google Scholar
  14. Erceg, C. J./Henderson/D. W., Levin, A. T. (1998): Tradeoffs between inflation and output-gap variances in a optimizing-agent model. International Finance Discussion Papers, No. 627, Federal Reserve Board.  Google Scholar
  15. Friedman, B. (1999): Comment. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 398–402.  Google Scholar
  16. Goodfriend, M./King, R. (1997): The new neoclassical synthesis and the role of monetary policy. In: Bernanke, B. S., Rotemberg, J. J. (Eds.), NBER Macroeconomics Annual 1997. MIT Press, Cambridge, pp. 233–283.  Google Scholar
  17. Gray, J. (1978): On indexation and contract length. Journal of Political Economy 86, pp. 1–18.  Google Scholar
  18. Henderson, D./McKibbin, W. (1993): A comparison of some basic monetary policy regimes for open economies: implications of different degrees of instrument adjustment and wage persistence. Carnegie-Rochester Series on Public Policy 39, pp. 221–317.  Google Scholar
  19. Ireland, P. N. (1997): A small structural, quarterly model for monetary policy evaluation. Carnegie- Rochester Series on Public Policy 47, pp. 83–108.  Google Scholar
  20. Kerr, W./King, R. G. (1996): Limits on interest rate rules in the IS model. Federal Reserve Bank of Richmond Economic Quarterly 82, pp. 47–75.  Google Scholar
  21. Keynes, J. M. (1935): The General Theory of Employment, Interest, and Money. Harcourt, Brace, and World, New York.  Google Scholar
  22. Kiley, M. T. (1998): Monetary policy under neoclassical and new-Keynesian Phillips curves, with an application to price level and inflation targeting. Finance and Economics Discussion Series No. 1998-27, Federal Reserve Board.  Google Scholar
  23. Kim, J. (2000): Constructing and estimating a realistic optimizing model of monetary policy. Journal of Monetary Economics 45, pp. 329–359.  Google Scholar
  24. Kimball, M. S. (1995): The quantitative analysis of the basic neomonetarist model. Journal of Money, Credit, and Banking 27, pp. 1241–1277.  Google Scholar
  25. King, R. G./Wolman, A. L. (1999): What should the monetary authority do when prices are sticky?. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 349–398.  Google Scholar
  26. Kollmann, R. (1997): The exchange rate in a dynamic-optimizing current account model with nominal rigidities: a quantitative investigation. Working paper, International Monetary Fund.  Google Scholar
  27. Levin, A. (1989): The theoretical and empirical relevance of staggered wage contract models. Ph.D. Dissertation, Stanford University.  Google Scholar
  28. Levin, A./Wieland, V./Williams, J. C. (1999): Robustness of simple monetary policy rules under model uncertainty. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 263–299.  Google Scholar
  29. McCallum, B. T./Nelson, E. (1999): Performance of operational policy rules in an estimated semiclassical structural model. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 349–398.  Google Scholar
  30. Phelps, E. S./Taylor, J. B. (1977): Stabilizing powers of monetary policy under rational expectations. Journal of Political Economy 85, pp. 163–190.  Google Scholar
  31. Rotemberg, J. J. (1996): Prices, output, and hours: an empirical analysis based on a sticky price model. Journal of Monetary Economics 37, pp. 505–533.  Google Scholar
  32. Rotemberg, J. J./Woodford, M. (1997): An optimization-based econometric framework for the evaluation of monetary policy. In: Bernanke, B. S., Rotemberg, J. J. (Eds.), NBER Macroeconomics Annual 1997. MIT Press, Cambridge, pp. 297–346.  Google Scholar
  33. Rotemberg, J. J./Woodford, M. (1999): Interest-rate rules in an estimated sticky price model. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 57–119.  Google Scholar
  34. Rudebusch, G. D./Svensson, L. E.O (1999): Policy rules for inflation targeting. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 203–246.  Google Scholar
  35. Solow, R./Stiglitz, J. (1968): Output, employment, and wages in the short run. Quarterly Journal of Economics 82, pp. 537–560.  Google Scholar
  36. Taylor, J. (1979): Staggered contracts in a macro model. American Economic Review 69, pp. 108–113.  Google Scholar
  37. Taylor, J. (1980): Aggregate dynamics and staggered contracts. Journal of Political Economy 88, pp. 1–24.  Google Scholar
  38. Taylor, J. B. (1993): Discretion versus policy rules in practice. Carnegie-Rochester Series on Public Policy 39, pp. 195–214.  Google Scholar
  39. Tetlow, R./von zur Muehlen, P. (1996): Monetary policy rules in a small forward-looking maco model. Processed, Federal Reserve Board.  Google Scholar
  40. Tetlow, R./von zur Muehlen, P. (1999): Simplicity versus optimality: the choice of monetary policy rules when agents must learn, Finance and Economics Discussion Series No. 1999-10, Federal Reserve Board.  Google Scholar
  41. Williams, J. C. (1999): Simple rules for monetary policy. Finance and Economics Discussion Series No. 1999-12, Federal Reserve Board.  Google Scholar
  42. Woodford, M. (1996): Control of the public debt: a requirement for price stability?. NBER Working Paper 5684, National Bureau of Economic Research.  Google Scholar
  43. Yun, T. (1996): Nominal price rigidity, money supply endogeneity, and business cycles. Journal of Monetary Economics 37, pp. 345–370.  Google Scholar
  44. Aizenman, J./Frenkel, J. A. (1986): Wage indexation, supply shocks, and monetary policy in a small open economy, In: Edwards, S., Ahamed, L. (Eds.), Economic Adjustment and Exchange Rate Changes in Developing Countries. University of Chicago Press, Chicago.  Google Scholar
  45. Anderson, G. S./Moore, G. (1985): A linear algebraic procedure for solving linear perfect foresight models. Economic Letters 17, pp. 247–252.  Google Scholar
  46. Barro, R. J. (1977): Long-term contracting, sticky prices, and monetary policy. Journal of Monetary Economics 3, pp. 305–316.  Google Scholar
  47. Blanchard, O. (1997): Comment, In: NBER Macroeconomics Annual 1997. MIT Press, Cambridge, MA, pp. 289–295.  Google Scholar
  48. Blanchard, O./Kahn, C. M. (1980): The solution of linear difference models under rational expectations. Econometrica 48, pp. 1305–1311.  Google Scholar
  49. Blanchard, O. J./Kiyotaki, N. (1987): Monopolistic competition and the effects of aggregate demand. American Economic Review 77 (4), pp. 647–666.  Google Scholar
  50. Bryant, R./Hooper, P./Mann, Z. C. (1993): Evaluating Policy Regimes: New Research in Empirical Macroeconomics. Brookings Institution, Washington, D.C.  Google Scholar
  51. Calvo, G. (1983): Staggered prices in a utility maximizing framework. Journal of Monetary Economics 12, pp. 383–398.  Google Scholar
  52. Canzoneri, M. B. (1980): Labor contracts and monetary policy. Journal of Monetary Economics 6, pp. 241–245.  Google Scholar
  53. Cuddington, J. T./Johansson, P.-O./Löfgren, K.-G. (1984): Disequilibrium Macroeconomics in Open Economies. Basil Blackwell, Oxford.  Google Scholar
  54. Dixit, A. K./Stiglitz, J. (1977): Monopolistic competition and optimum product diversity. American Economic Review 67, pp. 297–308.  Google Scholar
  55. Dotsey, M./King, R. G./Wolman, A. L. (1997): State dependent pricing and dynamics of business cycles. Working paper No. 97-2, Federal Reserve Bank of Richmond.  Google Scholar
  56. Erceg, C. J. (1997): Nominal wage rigidities and the propagation of monetary disturbances. International Finance Discussion Papers, No. 590, Federal Reserve Board.  Google Scholar
  57. Erceg, C. J./Henderson/D. W., Levin, A. T. (1998): Tradeoffs between inflation and output-gap variances in a optimizing-agent model. International Finance Discussion Papers, No. 627, Federal Reserve Board.  Google Scholar
  58. Friedman, B. (1999): Comment. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 398–402.  Google Scholar
  59. Goodfriend, M./King, R. (1997): The new neoclassical synthesis and the role of monetary policy. In: Bernanke, B. S., Rotemberg, J. J. (Eds.), NBER Macroeconomics Annual 1997. MIT Press, Cambridge, pp. 233–283.  Google Scholar
  60. Gray, J. (1978): On indexation and contract length. Journal of Political Economy 86, pp. 1–18.  Google Scholar
  61. Henderson, D./McKibbin, W. (1993): A comparison of some basic monetary policy regimes for open economies: implications of different degrees of instrument adjustment and wage persistence. Carnegie-Rochester Series on Public Policy 39, pp. 221–317.  Google Scholar
  62. Ireland, P. N. (1997): A small structural, quarterly model for monetary policy evaluation. Carnegie- Rochester Series on Public Policy 47, pp. 83–108.  Google Scholar
  63. Kerr, W./King, R. G. (1996): Limits on interest rate rules in the IS model. Federal Reserve Bank of Richmond Economic Quarterly 82, pp. 47–75.  Google Scholar
  64. Keynes, J. M. (1935): The General Theory of Employment, Interest, and Money. Harcourt, Brace, and World, New York.  Google Scholar
  65. Kiley, M. T. (1998): Monetary policy under neoclassical and new-Keynesian Phillips curves, with an application to price level and inflation targeting. Finance and Economics Discussion Series No. 1998-27, Federal Reserve Board.  Google Scholar
  66. Kim, J. (2000): Constructing and estimating a realistic optimizing model of monetary policy. Journal of Monetary Economics 45, pp. 329–359.  Google Scholar
  67. Kimball, M. S. (1995): The quantitative analysis of the basic neomonetarist model. Journal of Money, Credit, and Banking 27, pp. 1241–1277.  Google Scholar
  68. King, R. G./Wolman, A. L. (1999): What should the monetary authority do when prices are sticky?. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 349–398.  Google Scholar
  69. Kollmann, R. (1997): The exchange rate in a dynamic-optimizing current account model with nominal rigidities: a quantitative investigation. Working paper, International Monetary Fund.  Google Scholar
  70. Levin, A. (1989): The theoretical and empirical relevance of staggered wage contract models. Ph.D. Dissertation, Stanford University.  Google Scholar
  71. Levin, A./Wieland, V./Williams, J. C. (1999): Robustness of simple monetary policy rules under model uncertainty. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 263–299.  Google Scholar
  72. McCallum, B. T./Nelson, E. (1999): Performance of operational policy rules in an estimated semiclassical structural model. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 349–398.  Google Scholar
  73. Phelps, E. S./Taylor, J. B. (1977): Stabilizing powers of monetary policy under rational expectations. Journal of Political Economy 85, pp. 163–190.  Google Scholar
  74. Rotemberg, J. J. (1996): Prices, output, and hours: an empirical analysis based on a sticky price model. Journal of Monetary Economics 37, pp. 505–533.  Google Scholar
  75. Rotemberg, J. J./Woodford, M. (1997): An optimization-based econometric framework for the evaluation of monetary policy. In: Bernanke, B. S., Rotemberg, J. J. (Eds.), NBER Macroeconomics Annual 1997. MIT Press, Cambridge, pp. 297–346.  Google Scholar
  76. Rotemberg, J. J./Woodford, M. (1999): Interest-rate rules in an estimated sticky price model. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 57–119.  Google Scholar
  77. Rudebusch, G. D./Svensson, L. E.O (1999): Policy rules for inflation targeting. In: Taylor, J. (Ed.), Monetary Policy Rules. The University of Chicago Press, Chicago, pp. 203–246.  Google Scholar
  78. Solow, R./Stiglitz, J. (1968): Output, employment, and wages in the short run. Quarterly Journal of Economics 82, pp. 537–560.  Google Scholar
  79. Taylor, J. (1979): Staggered contracts in a macro model. American Economic Review 69, pp. 108–113.  Google Scholar
  80. Taylor, J. (1980): Aggregate dynamics and staggered contracts. Journal of Political Economy 88, pp. 1–24.  Google Scholar
  81. Taylor, J. B. (1993): Discretion versus policy rules in practice. Carnegie-Rochester Series on Public Policy 39, pp. 195–214.  Google Scholar
  82. Tetlow, R./von zur Muehlen, P. (1996): Monetary policy rules in a small forward-looking maco model. Processed, Federal Reserve Board.  Google Scholar
  83. Tetlow, R./von zur Muehlen, P. (1999): Simplicity versus optimality: the choice of monetary policy rules when agents must learn, Finance and Economics Discussion Series No. 1999-10, Federal Reserve Board.  Google Scholar
  84. Williams, J. C. (1999): Simple rules for monetary policy. Finance and Economics Discussion Series No. 1999-12, Federal Reserve Board.  Google Scholar
  85. Woodford, M. (1996): Control of the public debt: a requirement for price stability?. NBER Working Paper 5684, National Bureau of Economic Research.  Google Scholar
  86. Yun, T. (1996): Nominal price rigidity, money supply endogeneity, and business cycles. Journal of Monetary Economics 37, pp. 345–370.  Google Scholar

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 achieve the Pareto-optimal equilibrium that would occur under completely flexible ­wages and prices; that is, the model exhibits a tradeoff in stabilizing the output gap, price inflation, and wage inflation. We characterize the optimal policy rule for reasonable calibrations of the model. We also find that strict price inflation targeting generates relatively large welfare losses, whereas several other simple policy rules perform nearly as well as the optimal rule.