Calvo Contracts - Optimal Indexation in General Equilibrium

Calvo contracts, which are the basis of the current generation of New Keynesian models, widely include indexation to general inflation. We argue that the indexing formula should be expected inflation rather than lagged inflation. This is likely to optimise the welfare of the representative agent in a general equilibrium model of the New Keynesian type. The economy's behaviour under rational indexation is similar to that of a New Classical model, with shocks producing an immediate fluctuation in both prices and output followed by a fairly rapid return to steady state. A monetary policy that targets the price level increases economic stability.