Price stickiness and wage stickiness in generalised new Keynesian model

Given different non-zero annual target inflation rates, we extend the standard new Keynesian dynamic stochastic general equilibrium (DSGE) model to allow both staggered price setting and staggered wage setting and derive a generalised version of new Keynesian model to study how these distortions affect the steady state and dynamics of model. The main finding is that the imperfection of labour market has more distortionary power on aggregate output and aggregate welfare given positive target inflation rate. The change in structural parameters that represents the monopolistic competition in intermediate-good market and labour market result in asymmetric distortion effect on the steady state of aggregate output and aggregate welfare. This asymmetric effect is especially significant given higher target inflation rate. Given the same target inflation rate, wage stickiness is more distortionary than the price stickiness. The existence of positive target inflation rate can also change the first-order dynamics of model, amplifying or reducing the dynamic response of model according to the type of exogenous shocks. Numerical results also provide us a macroeconomic structural model-based explanation for the reason that the most central banks set the target inflation rate within a range from 1% to 2%.