DP5616 Calvo Contracts - Optimal Indexation in General Equilibrium

Author(s): Vo Phuong Mai Le, Patrick Minford
Publication Date: April 2006
Keyword(s): Calvo contracts, indexing, New Keynesian
JEL(s): E0
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5616

Calvo contracts, which are the basis of the current generation of New Keynesian models, widely include indexation to general inflation. We argue that the indexing formula should be expected inflation rather than lagged inflation. This optimises the welfare of the representative agent in a general equilibrium model of the New Keynesian type. This is shown analytically for a simplified model and by numerical simulation for a full model with price and wage contracts as well as capital. The consequence of such indexation is that monetary policy no longer has any effect on welfare.