Jel Classification
E24, E3, E5, O41, J64
N° Pages
Monetary policy invariance, hysteresis, and optimal inflation

Standard New Keynesian (NK) models feature an optimal inflation target well below 2 percent, limited welfare losses from business cycle fluctuations and long-term monetary neutrality. We develop a NK framework with endogenous productivity and downward wage rigidity (DWR) which challenges these results. The interaction between endogenous growth and DWR generates asymmetric hysteresis effects on unemployment and R&D. As a consequence, the model features a non-vertical long-run Phillips curve and a trade-off between price distortions and output hysteresis that changes the welfare-maximizing inflation rate to above 2 percent. Deviations from the optimal target carry welfare costs multiple times those in traditional NK models. Taylor rules responding to labor market developments handle better the asymmetric hysteresis effects in our model. Results are robust to the inclusion of the effective lower bound on interest rates.

Endogenous Growth, Monetary Policy, Optimal Inflation Target, Downward Wage Rigidity, Monetary Policy Invariance, Zero Lower Bound