Optimal monetary policy and downward nominal wage rigidity in frictional labor markets

Abstract

This paper studies the optimal long-run inflation rate in a labor search and matching framework in the presence of downward nominal wage rigidity. Optimal monetary policy features positive inflation in the long run; the optimal annual long-run inflation rate for the U.S. economy is slightly below 1 percent with a money demand motive and around 2 percent otherwise. Positive inflation facilitates real wage adjustments and hence it eases job creation and prevents excessive increase in unemployment following adverse productivity shocks. The findings of the paper can also be related to standard Ramsey theory of “wedge smoothing”; with positive inflation under sticky prices, the size and the volatility of the intertemporal wedge are significantly reduced.