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We acknowledge Yuriy Gorodnichenko and Juan Rubio-Ramirez for helpful comments and suggestions at an early stage of this project, Sylvain Leduc for useful comments on the current draft and Jean-Gardy Victor for capable research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.© 2015 by Guido Ascari, Louis Phaneuf, and Eric Sims. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. ABSTRACTWe offer a comprehensive evaluation of the welfare and cyclical implications of moderate trend inflation. In an extended version of a medium-scale New Keynesian model, recent proposals to increase trend inflation from 2 to 4 percent would generate a consumption-equivalent welfare loss of 3.7 percent based on the non-stochastic steady state and of 6.9 percent based on the stochastic mean. Welfare costs of this magnitude are driven by four main factors: i) multiperiod nominal wage contracting, ii) trend growth in investment-specific and neutral technology, iii) roundaboutness in the U.S. production structure, and iv) and the interaction between trend inflation and shocks to the marginal efficiency of investment (MEI), insofar that this type of shock is sufficiently persistent. Moreover, moderate trend inflation has important cyclical implications. It interacts much more strongly with MEI shocks than with either productivity or monetary shocks.

The cyclical behavior of real wages has evolved from mildly countercyclical during the interwar period to modestly procyclical in the postwar era. This paper presents a general-equilibrium business-cycle model that helps explain the evolution. In the model, changes in the real wage cyclicality arise from interactions between nominal wage and price rigidities and an evolving input-output structure.

We acknowledge Yuriy Gorodnichenko and Juan Rubio-Ramirez for helpful comments and suggestions at an early stage of this project, Sylvain Leduc for useful comments on the current draft and Jean-Gardy Victor for capable research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

We use a dynamic general equilibrium model to obtain quantitative estimates of the welfare cost of nominal wage contracting. We find that the welfare cost of such contracts can vary quite a lot depending on the degree of indexation, the size and persistence of monetary shocks and the contract length. The size and persistence of technology shocks do not affect the welfare cost significantly. The elasticity of labour supply is important for the welfare cost. If the labour supply elasticity is small the welfare cost of nominal wage contracts can be substantial.

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