Output-gap and Price Inflation Volatilities:
Reaffirming Tradeoffs in an Optimizing Model
by
Cristopher J. Erceg, Dale W. Henderson
and Andrew T. Levin
Conference on Monetary Policy Rules
Stockholm 12 – 13 June 1998
Sveriges Riksbank
and
Institute for International Economic Studies,
Stockholm University
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FIGURE 1
FIGURE 2
FIGURE 3
FIGURE 4
FIGURE 5
FIGURE 6
Chart 1: Complete Price and Output Stabilization
Staggered Price Setting and Flexible Wages
Consumption Shock
1
Prices and Output Gap
0.5
Potential Output
0
Wage Inflation
Interest Rate
−0.5
−1
0
2
4
6
8
10
12
14
16
18
20
12
14
16
18
20
14
16
18
20
Change in Percentage Points
Leisure Shock
1
0.5
0
−0.5
−1
0
2
4
6
8
10
Productivity Shock
1.5
1
0.5
0
−0.5
−1
−1.5
0
2
4
6
8
10
Periods
12
Chart 2: Impulse Responses for Productivity Shocks
Staggered Wage Contracts and Flexible Prices (alpha = 0)
Output Gap
Price Inflation
2
25
1.5
Change in Percentage Points
30
20
15
10
5
0
−5
−10
Price inflation target
Output gap target
1
0.5
0
−0.5
−1
−1.5
0
5
10
15
−2
20
0
5
Wage Inflation
15
20
15
20
Interest Rate
2
10
Change in Percentage Points
1.5
1
0.5
0
−0.5
−1
−1.5
−2
10
0
5
10
Periods
15
20
0
−10
−20
−30
−40
−50
0
5
10
Periods
Chart 3
Variance Tradeoff under Sticky Wages (al ha = 0)
Productivity Shocks
1.8
1.6
1.4
Price Inflation Variance
1.2
1
0.8
0.6
0.4
0.2
0
0
20
40
60
80
Output Gap Variance
100
120
140
Chart 4: Impulse Responses for Consumption Shocks
Staggered Wage Contracts and Flexible Prices (alpha = 0.3)
Output Gap
Price Inflation
1
Change in Percentage Points
1
0.5
0
−0.5
−1
0
5
10
15
Price inflation target
0
−0.5
−1
20
Output gap target
0.5
0
5
Wage Inflation
15
20
15
20
Interest Rate
2
Change in Percentage Points
1
0.5
0
−0.5
−1
10
0
5
10
Periods
15
20
1.5
1
0.5
0
−0.5
−1
0
5
10
Periods
Chart 5: Impulse Responses for Leisure Shocks
Staggered Wage Contracts and Flexible Prices (alpha = 0.3)
Output Gap
Price Inflation
1
Change in Percentage Points
1
0.5
0
−0.5
−1
0
5
10
15
Price inflation target
0
−0.5
−1
20
Output gap target
0.5
0
5
Wage Inflation
15
20
15
20
Interest Rate
1
Change in Percentage Points
1
0.5
0
−0.5
−1
10
0
5
10
Periods
15
20
0.5
0
−0.5
−1
0
5
10
Periods
Chart 6: Impulse Responses for Productivity Shocks
Staggered Wage Contracts and Flexible Prices (alpha = 0.3)
Output Gap
Price Inflation
2
2.5
1.5
Change in Percentage Points
3
2
1.5
1
0.5
0
−0.5
−1
Price inflation target
Output gap target
1
0.5
0
−0.5
−1
−1.5
0
5
10
15
−2
20
0
5
Wage Inflation
15
20
15
20
Interest Rate
2
1.5
1.5
Change in Percentage Points
2
1
0.5
0
−0.5
−1
−1.5
−2
10
1
0.5
0
−0.5
−1
−1.5
0
5
10
Periods
15
20
−2
0
5
10
Periods
Chart 7: Productivity Shock Effects under Different Contract Lengths
Staggered Wage Contracts and Flexible Prices (alpha = 0.3)
Output Gap
Price Inflation
2
2.5
1.5
Four−quarter average duration
1
Two−quarter average duration
Change in Percentage Points
3
2
1.5
1
0.5
0
−0.5
−1
0.5
0
−0.5
−1
−1.5
0
5
10
15
−2
20
0
5
Wage Inflation
15
20
15
20
Interest Rate
2
1.5
1.5
Change in Percentage Points
2
1
0.5
0
−0.5
−1
−1.5
−2
10
1
0.5
0
−0.5
−1
−1.5
0
5
10
Periods
15
20
−2
0
5
10
Periods
Chart 8
Variance Tradeoff under Sticky Wages (al ha = 0.3)
Consumption Shocks
0.2
0.18
0.16
Price Inflation Variance
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
0
0.05
0.1
0.15
0.2
0.25
Output Gap Variance
0.3
0.35
0.4
0.45
Chart 9
Variance Tradeoff under Sticky Wages (al ha = 0.3)
Leisure Shocks
0.2
0.18
0.16
Price Inflation Variance
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
0
0.05
0.1
0.15
0.2
0.25
Output Gap Variance
0.3
0.35
0.4
0.45
Chart 10
Variance Tradeoff under Sticky Wages (al ha = 0.3)
Productivity Shocks
3
2.5
Price Inflation Variance
2
1.5
1
0.5
0
0
1
2
3
Output Gap Variance
4
5
6
Chart 11
Variance Tradeoff under Sticky Wages and Sticky Prices
Consumption Shocks
−3
8
x 10
7
Price Inflation Variance
6
5
4
3
2
1
0
0
0.05
0.1
0.15
0.2
0.25
Output Gap Variance
0.3
0.35
0.4
0.45
Chart 12
Variance Tradeoff under Sticky Wages and Sticky Prices
Leisure Shocks
−3
8
x 10
7
Price Inflation Variance
6
5
4
3
2
1
0
0
0.05
0.1
0.15
0.2
0.25
0.3
Output Gap Variance
0.35
0.4
0.45
0.5
Chart 13
Variance Tradeoff under Sticky Wages and Sticky Prices
Productivity Shocks
0.1
0.09
0.08
Price Inflation Variance
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
0
0.5
1
Output Gap Variance
1.5
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