Academic journal article Journal of Money, Credit & Banking

The Cost of Nominal Rigidity in NNS Models

Academic journal article Journal of Money, Credit & Banking

The Cost of Nominal Rigidity in NNS Models

Article excerpt

We present a model with Calvo wage and price setting, capital formation, and estimated rules for government spending and monetary policy. Our model captures many aspects of U.S. data, including the volatility that has been observed in various efficiency gaps. We estimate the cost of nominal rigidity--welfare under flexible wages and prices minus welfare with nominal rigidities--to be as much as 3 % of consumption each period. Since there are interest rate rules that virtually eliminate this cost, our model suggests that--contrary to Lucas's (2003) assertion--there is considerable room for improvement in demand management policy.

JEL codes: E52, E32

Keyword: cost of nominal rigidity.

THE NEW NEOCLASSICAL SYNTHESIS (NNS) is characterized by monopolistic competition, wage, and/or price stickiness, and demand determination of output and employment. The NNS has been used to revisit the central issues of stabilization policy, and a number of theoretical insights have emerged. Rotemberg and Woodford (1997) showed that smoothing output--which was strongly emphasized in traditional Keynesian analyses--can lower household welfare in a model driven by productivity shocks. A number of papers have shown that the trade-offs for monetary policy can depend on the type of nominal rigidity that is postulated. For example, King and Wolman (1999) showed that there was no inflation-output trade-off in a model with staggered price setting; the optimal policy in their model was to stabilize the price level. By contrast, Erceg, Henderson, and Levin (2000) (EHL) showed that an inflation-output trade-off can emerge in a model with both staggered wage setting and staggered price setting. (1)

But, are these theoretical insights of any practical import? A challenge hanging over this new literature on monetary policy is Lucas's claim that the macroeconomic stabilization problem has been solved: "Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply-side policies exceeds by far the potential from further improvements in short-run demand management" (Lucas 2003, p. 1).

In this paper, we calibrate a standard NNS model--with wage and price stickiness, capital formation, and empirically estimated rules for public spending and the cental bank's interest rate policy--to U.S. data, and we use the model to calculate the welfare cost of wage and price rigidities. We express the cost as the consumption an average household would be willing to give up each period to obtain the flexible wage/price solution. Our estimate of the cost of nominal rigidities is large: between 1% and 3% of consumption. We think that a welfare cost of this magnitude is worth caring about. We also show that there exist simple interest rate rules that would nearly eliminate this welfare cost. This suggests to us that there may be considerable room for improvement in demand management policies.

NNS models typically envision a production economy with complete consumption risk sharing. In such an environment, it is natural to associate the welfare cost of nominal rigidity with variations in the gap between the marginal product of labor (MPL) and the marginal rate of substitution (MRS) between consumption and leisure. EHL motivated their analysis in this way, but the welfare losses they found were quite small, suggesting that the variations in this gap generated by their model would also be small. (2) By contrast, Gali, Gertler, and Lopez-Salido (Forthcoming) (GGLS) developed empirical proxies for the MRS-MPL gap, and found that the gap was quite volatile, much more volatile than output. GGLS did not present a model, so it was not clear that an NNS model could generate the gap volatility they observed in the data.

There are several possible interpretations of the contrasting results of EHL and GGLS. Productivity shocks are the only source of uncertainty in EHL's model, and the monetary policies that EHL consider are all reasonably good in NNS models that are driven by productivity shocks. …

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