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

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 Gali (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.