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.
E24, E3, E5, O41, J64
Monetary policy invariance, hysteresis, and optimal inflation
KeywordsEndogenous Growth, Monetary Policy, Optimal Inﬂation Target, Downward Wage Rigidity, Monetary Policy Invariance, Zero Lower Bound