DP6325 | Optimising Indexation Arrangements under Calvo Contracts and their Implications for Monetary Policy

Publication Date

23/06/2007

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Abstract

This paper investigates optimal indexation in the New Keynesian model, when the indexation choice includes the possibility of partial indexation and of varying weights on rational and lagged indexation. It finds that the Calvo contract adjusted for rationally expected indexation under both inflation and price level targeting regimes delivers the highest expected welfare under both restricted and full current information. Rational indexation eliminates the effectiveness of monetary policy on welfare when there is only price-level targeting under the current micro information. If including both wage setting and full current information, monetary policy is effective; and a price-level targeting rule delivers the highest benefits because it minimises the size of shocks to prices and thus dispersion. However, even less than full rational indexation ensures that there is very little nominal rigidity in the adapted world of Calvo contracts.