ESSAYS ON THE OPTIMAL LONG-RUN INFLATION RATE
Abo Zaid, Salem M.
Chugh, Sanjay K
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Chapter 1: Optimal Long-Run Inflation with Occasionally-Binding Financial Constraints. This paper studies the optimal inflation rate in a simple New Keynesian model with occasionally-binding collateral constraints that intermediate-good firms face on hiring labor. For empirically-relevant degrees of price rigidity, the optimal long-run annual inflation rate is in the range of half a percent to 2 percent, depending on whether it is TFP risk or markup risk or both that is the source of uncertainty in the economy. The shadow value on the collateral constraint is akin to an endogenous cost-push shock. Differently from usual cost-push shocks, however, this shock is asymmetric as it takes non-negative values only. Inflation is positive when the collateral constraint is binding and it is zero when it does not. Since the mean of this asymmetric endogenous cost-push shock is positive, inflation is also positive on average. In addition, a binding collateral constraint resembles a time-varying tax on labor, which the monetary authority can smooth by setting a positive inflation rate. More generally, the basic result is related to standard Ramsey theory in that optimal policy smoothes distortions over time. Chapter 2: Optimal Monetary Policy and Downward Nominal Wage Rigidity in Frictional Labor Markets. Empirical evidence suggests that nominal wages in the U.S. are downwardly rigid. This paper studies the optimal long-run inflation rate in a labor search and matching framework under the presence of Downward Nominal Wage Rigidity (DNWR). In this environment, optimal monetary policy targets a positive inflation rate; the annual long-run inflation rate for the U.S. is around 2 percent. Positive inflation "greases the wheels" of the labor market by facilitating real wage adjustments, and hence it eases job creation and prevents excessive increase in unemployment following recessionary shocks. These findings are related to standard Ramsey theory of "wedge smoothing"; by following a positive-inflation policy under sticky prices, the monetary authority manages to reduce the volatility and the size of the intertemporal distortion significantly. The intertemporal wedge is completely smoothed when prices are fully flexible. Since the optimal long-run inflation rate predicted by this study is considerably higher than in otherwise neoclassical labor markets, the nature of the labor market in which DNWR is studied can be relevant for policy recommendations. Chapter 3: Sticky Wages, Incomplete Pass-Through and Inflation Targeting: What is the Right Index to Target? This paper studies strict monetary policy rules in a small open economy with Inflation Targeting, incomplete pass-through and rigid nominal wages. The paper shows that, when nominal wages are fully flexible and pass-through is low to moderate, the monetary authority should target the Consumer Price Index (CPI) rather than the Domestic Price Index (DPI). When pass-through is high, an economy with high degrees of nominal wage rigidity and wage indexation should either target the CPI or fully stabilize nominal wages. These results suggest that, by committing to a common monetary policy in a common-currency area, some countries may not be following the right monetary policy rules.