Working Paper: CEPR ID: DP6325
Authors: Vo Phuong Mai Le; Patrick Minford
Abstract: This paper investigates optimal indexation in the New Keynesian model, when the indexation choice includes the possibility of partial indexation and of varying weights on rational and lagged indexation. It finds that the Calvo contract adjusted for rationally expected indexation under both inflation and price level targeting regimes delivers the highest expected welfare under both restricted and full current information. Rational indexation eliminates the effectiveness of monetary policy on welfare when there is only price-level targeting under the current micro information. If including both wage setting and full current information, monetary policy is effective; and a price-level targeting rule delivers the highest benefits because it minimises the size of shocks to prices and thus dispersion. However, even less than full rational indexation ensures that there is very little nominal rigidity in the adapted world of Calvo contracts.
Keywords: Calvo Contracts; Inflation Target; New Keynesian Model; Optimal Indexation; Price-Level Target; Rational Expectation
JEL Codes: E50; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Rational indexation (C43) | Expected welfare (D69) |
| Rational indexation eliminates the effectiveness of monetary policy on welfare under price-level targeting (E31) | Expected welfare (D69) |
| Monetary policy becomes effective when wage setting and full current information are accounted for (E64) | Expected welfare (D69) |
| Degree of indexation (C43) | Nominal rigidity (D50) |
| Rational indexation (C43) | New Classical Phillips curve (E31) |
| Choice of monetary policy target (inflation vs. price-level) does not significantly affect welfare when rational indexation is employed (E31) | Expected welfare (D69) |