On time-dependent nominal contracting models with positive trend inflation

Abstract

We compare the cyclical and welfare implications of positive trend inflation in Taylor (1980) and Calvo (1983) nominal contracting models. Taylor contracts better match the correlations between nominal real variables. They generate persistent and hump-shaped responses of inflation to monetary policy and investment shocks without indexation, while Calvo contracts do not. Trend inflation has significant distorting effects on the shock impulse responses of key variables with Calvo contracts, but not with Taylor contracts. The correlation between price dispersion and trend inflation is weaker with Taylor contracts. With Calvo contracts, wage dispersion and inflation costs are very sensitive to positive trend inflation under plausible variations in the average age of wage contracts, the elasticity of substitution between skills, economic growth, and labor supply elasticity. They are much more stable with Taylor contracts. Still, based on Taylor contracts, the consumer-equivalent welfare gains resulting from a lower inflation trend after 1982 may range from 3.1% to 7.5%.