Scandinavian Working Papers in Economics

Seminar Papers,
Stockholm University, Institute for International Economic Studies

No 650: Tradeoffs Between Inflation and Output-Gap Variances in an Optimizing-Agent Model

Christopher J. Erceg (), Dale W. Henderson and Andrew T. Levin
Additional contact information
Christopher J. Erceg: Division of International Finance of the Federal Reserve Board, Postal: Federal Reserve Board, Stop 24, Washington DC 20551, USA
Dale W. Henderson: Division of International Finance of the Federal Reserve Board, Postal: Federal Reserve Board, Stop 24, Washington DC 20551, USA
Andrew T. Levin: Division of International Finance of the the Federal Reserve Board, Postal: Federal Reserve Board, Stop 24, Washington DC 20551, USA

Abstract: We demonstrate the existence of a monetary policy tradeoff between price-inflation variability and output-gap variability in an optimizing-agent model with staggered nominal wage and price contracts. This variance tradeoff is absent only in the special case in which prices are sticky and wages are perfectly flexible. When the model is calibrated to exhibit an empirically reasonable degreee of nominal wage inertia, strict inflation targeting induces substantial output-gap volatility.

Keywords: monetary policy tradeoff; price-inflation variability; output-gap variability

JEL-codes: E42; E52

41 pages, September 1, 1998

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