Endogenous Growth, Downward Wage Rigidities and Optimal Inflation

IMF Working Papers, August 6, 2021

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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.
This paper develops 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.
Deviations from the optimal target carry welfare costs multiple times higher than in traditional NK models.
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 better handle the asymmetric and hysteresis effects and deliver significant welfare gains.
Results are robust to the inclusion of the effective lower bound on the monetary policy interest rate.

The long-run Phillips curve is non-vertical: inflation and unemployment exhibit a persistent relationship when incorporating endogenous growth and DWR.
Optimal inflation with endogenous growth and DWR can exceed two percent for plausible parameterizations.
Welfare costs from deviating from the optimal inflation target are multiple times higher than in traditional NK models because of asymmetric and hysteresis effects on unemployment and output.
Monetary regimes that directly address level effects (price level targeting) or respond to unemployment (Taylor-rule with unemployment response) perform better in this setup.

Consider higher inflation targets than the conventional two percent in environments where endogenous growth and DWR are relevant, as the welfare-maximizing inflation may be in excess of two percent.
Adopt monetary frameworks that mitigate asymmetric and hysteresis effects:
- Price level targeting.
- Taylor-rule formulations that respond to the unemployment rate.
Account for the effective lower bound in policy design; the main results remain robust when the effective lower bound on the monetary policy interest rate is included.

The paper assesses robustness to the inclusion of the effective lower bound on the monetary policy interest rate and reports that results hold.
The analysis highlights asymmetric and hysteresis dynamics in unemployment and output arising from the interaction of endogenous growth and downward wage rigidity.