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BWPEF 1701
Adiya Belgibayeva and Michal Horvath
Real Rigidities and Optimal Stabilization at the Zero Lower Bound in New Keynesian Economies

The paper re-visits the literature on real rigidities in New Keynesian models in the context of an economy at the zero lower bound. It identifies strategic interaction among price- and wage-setting agents in the economy as an important determinant of both optimal policy and economic dynamics in deep recessions. In particular, labour market segmentation is shown to have a significant influence on the length of the forward commitment to keep interest rates at zero, the magnitude of the fiscal policy responses as well as inflation volatility in the economy under optimal policy.

Keywords: zero lower bound, strategic complementarity, labour market, inflation, income tax, government spending.

JEL classification: E31, E32, E52, E61, E62.

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