## Endogenous Growth, Downward Wage Rigidities and Optimal Inflation

_IMF Working Papers, August 6, 2021_

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**Canonical URL:** [Endogenous Growth, Downward Wage Rigidities and Optimal Inflation](https://www.imf.org/en/publications/wp/issues/2021/08/06/endogenous-growth-downward-wage-rigidities-and-optimal-inflation-462360)

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## Bibliographic details
- Authors: Mirko Abbritti, Agostino Consolo, Sebastian Weber
- Published: August 6, 2021
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513583983.001

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### Summary
- 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.

### Key findings
- 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.

### Policy implications and recommendations
- 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.

### Robustness and scenarios
- 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2021/08/06/endogenous-growth-downward-wage-rigidities-and-optimal-inflation-462360_