Nominal Contracting With Positive Trend Inflation: Which Way to Go?

Louis Phaneuf and Jean Gardy Victor
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Louis Phaneuf: University of Quebec in Montreal
Jean Gardy Victor: Desjardins Group

No 20-04, Working Papers from Chair in macroeconomics and forecasting, University of Quebec in Montreal's School of Management

Abstract: We offer evidence questioning the wide use of Calvo contracts in the DSGE literature since the mid1990s. We contrast the cyclical and welfare implications of Taylor (1980) and Calvo (1983) nominal contracts in medium-scale DSGE models with positive trend inflation. Taylor contracts better match comovements between inflation, nominal interest rate and real variables. They also generate persistent and hump-shaped responses of inflation to monetary policy and investment shocks, while Calvo contracts do not. Calvo contracts can imply very strong monopolistic distortions. Also, steady state wage dispersion and consumer equivalent welfare losses generated by trend inflation are highly sensitive to plausible variations in the average age of wage contracts, the degree of substitutability among labor skills, economic growth, and the Frisch elasticity of labor supply. Distortions are weaker, and wage dispersion and inflation costs are much smaller under Taylor contracts. We nonetheless estimate that with Taylor contracts the welfare benefits of going from 7% trend inflation as in the pre-1980s to 3% after the early 1980s may have reached 7%. The Fed being held accountable for the decline in trend inflation, this suggests the welfare benefits from bringing inflation down were potentially important.

Keywords: Trend Inflation; Taylor and Calvo Contracts; Wage Dispersion; Welfare Costs; Inflation Dynamics. (search for similar items in EconPapers)
JEL-codes: E31 E32 E37 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2020-05
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