Could the UK’s monetary policy be improved by targeting nominal GDP? A model of the UK with state-dependent price/wage contracts

Abstract

There is substantial evidence from both macro and micro data that the durations of price/wage contracts vary with the state of the economy, particularly with inflation. This thesis investigates whether there is macro-level evidence of state-dependent price/wage contracts in the UK and examines the policy implications of a UK macroeconomic model in the presence of state-dependent variation. Two versions of the price/wage-setting framework are considered in this thesis: a fixed price/wage contract duration framework and a state-dependent duration framework. Each framework is incorporated into an open economy Dynamic Stochastic General Equilibrium (DSGE) model. It combines the New Keynesian and New Classical models into a hybrid model, incorporates financial friction, and includes several new developments in the wake of the recent Great Financial Crisis, including allowing for zero lower bound and quantitative easing. The fixed duration and state-dependent models are tested and estimated over the whole sample period 1955-2021 for the UK macroeconomic data using a simulation-based Indirect Inference method. The main findings of this thesis are: 1) the fixed duration model fits the behaviour of the UK data for the inflation targeting era 1992-2021, but not for the whole sample period 1955-2021; 2) The state-dependent model fits the behaviour of the UK historical data well over the whole sample period 1955-2021, implying that the state-dependent price/wage contract framework improves the fit of the DSGE model to the macroeconomic data. Furthermore, the durations of price/wage contracts fluctuate with the state of the economy (especially inflation) throughout the whole sample period; 3) A nominal GDP targeting rule together with a fiscal backstop to prevent zero lower bound can reduce the chances of economic crisis and stabilise the UK macroeconomy. Therefore, it outperforms the Taylor Rule regime