How Do Nominal and Real Rigidities Interact? A Tale of the Second Best


  • The views that are expressed in the paper are those of the authors and do not necessarily reflect views of the OECD or the European Commission. We thank the editor Pok-sang Lam and two anonymous referees for very valuable comments and suggestions.


This paper analyzes the importance of real wage rigidities, in particular through their interaction with price stickiness, in a New Keynesian model. Real wage rigidities result from a combination of staggered wage setting and partial indexation of nonreset wages to past inflation. Blanchard and Galí (2007) show real rigidities to introduce a trade-off between stabilizing inflation and the welfare-relevant output gap. The present paper complements their findings by showing that the welfare costs of real rigidities can be substantial compared to nominal frictions. In a typical “tale of the second best,” we also show that in the presence of real wage rigidities, higher price stickiness can be welfare enhancing.