Optimal monetary policy and downward nominal wage rigidity in frictional labor markets

Abstract

Recent empirical evidence suggests that nominal wages in the U.S. are downwardly rigid. This paper studies optimal monetary policy in a labor search and matching framework under the presence of Downward Nominal Wage Rigidity (DNWR). The study shows that when nominal wages are downwardly rigid, optimal monetary policy targets a positive inflation rate; the annual long-run inflation rate is around 2 percent. Positive inflation in this environment "greases the wheels" of the labor market by facilitating real wage adjustments, and hence it eases job creation and prevents excessive increase in unemployment. In addition, there is an asymmetry in the response of the economy to positive and negative productivity shocks, particularly those of large sizes. Finally, the optimal long-run inflation rate predicted by this study is considerably higher than in otherwise neoclassical labor markets, suggesting that the nature of the labor market in which DNWR is studied can matter for policy recommendations.

A Theory of Wage Adjustment Under Loss Aversion

“…Second, while symmetric nominal rigidities give rise to a long-run Phillips curve which is virtually vertical (e.g. Goodfriend and King, 1997;Khan et al, 2003), downward nominal wage rigidity leads to a signi…cantly non-vertical long-run Phillips curve, thereby generating substantial long-run real e¤ects of monetary policy on output and employment for negative shocks, as shown by Ruge-Murcia (2009, 2011), Fagan and Messina (2009), Fahr and Smets (2010), Benigno and Ricci (2011) and Abo-Zaid (2013). In all of these latter contributions, The paper is structured as follows.…”