The Optimality of Nominal Income Targeting When Wages Are Indexed to Price

Abstract

In the last decade there has been renewed interest in alternative monetary regimes, institutions, and policy procedures. One policy proposal that has received increased attention is nominal income targeting. This proposal has been suggested, for instance, by Feldstein [9], Gordon [13], Hall [16], Meade [21], and Tobin [25; 26]. Taylor [24] discusses this proposal in some detail, and McCallum [20] presents a statistical analysis of a particular nominal income targeting rule in a variety of contexts. Bean [3] presents a theoretical analysis of nominal income targeting, examining the properties of such a policy in a stochastic macro model in which rational agents sign nominal wage contracts. Given that the monetary authority's objective is to minimize the divergence of output from its full information level, nominal income targeting is the optimal policy if labor supply is perfectly inelastic. With an elastic labor supply, however, nominal income targeting provides the optimal response to demand side shocks but not to supply side shocks. The problem of designing optimal policy in the face of both demand and supply side shocks is not new. Authors such as Benavie and Froyen [4], Craine and Havenner [8], Parkin [22], and Turnovsky [27] have stressed that pure policy rules such as a strict money rule or an interest rate peg are generally not the optimal policy response to both demand and supply shocks. Thus Bean's result, that nominal income targeting provides the optimal policy response to all shocks (as long as labor supply is perfectly inelastic), is rather impressive. One avenue of research that attempts to provide a partial solution to the problem of suboptimal policy rules in the face of demand and supply shocks is the investigation of wage indexing. Work by Gray [14; 15] drew attention to the properties of nominal wage contracts indexed to the price level. The relation between the monetary authority's choice of policy rule and the degree of indexing in the labor market has been investigated by Fethke and Policano [11], Fethke and