Optimal Monetary Policy and Downward Nominal Wage Rigidity in Frictional Labor Markets.

Empirical evidence suggests that nominal wages in the U.S. are downwardly rigid. This paper studies the optimal long-run inflation rate in a labor search and matching framework under the presence of Downward Nominal Wage Rigidity (DNWR). In this environment, optimal monetary policy targets a positive inflation rate; the annual long-run inflation rate for the U.S. is around 2 percent. Positive inflation “greases the wheels” of the labor market by facilitating real wage adjustments, and hence it eases job creation and prevents excessive increase in unemployment following recessionary shocks. These findings are related to standard Ramsey theory of “wedge smoothing”; by following a positive-inflation policy under sticky prices, the monetary authority manages to reduce the volatility and the size of the intertemporal distortion significantly. The intertemporal wedge is completely smoothed when prices are fully flexible. Since the optimal long-run inflation rate predicted by this study is considerably higher than in otherwise neoclassical labor markets, the nature of the labor market in which DNWR is studied can be relevant for policy recommendations.