UK monetary policy in an estimated DSGE model with state-dependent price and wage contracts

Abstract

This study incorporates state-dependent price/wage setting into a small open economy DSGE model to investigate whether, with this feature, the model can better explain the UK business cycle dynamics. The model is estimated and tested using the Indirect Inference method and is found to fit the dynamic behaviour of key variables very well over a long sample period 1955–2021 which includes episodes with the Zero lower Bound, ZLB. The model implications for policy improvement are that in the presence of state-dependence and the ZLB, monetary-fiscal coordination is needed to stabilise the economy, as monetary policy alone cannot achieve economic stability during ZLB scenarios, where it must use bond purchases (Quantitative Easing, QE). Our findings suggest that a coordinated monetary-fiscal policy framework, i.e., an interest rate policy that targets nominal GDP complemented by a ZLB-suppressing fiscal policy, decreases the frequency of economic crises and enhances price/output stability and household welfare compared to the baseline Taylor Rule and QE framework.