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Gaps and Triangles

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  • Bernardino Adao
  • Isabel Correia
  • Pedro Teles

Abstract

In this paper, we derive principles of optimal cyclical monetary policy in an economy without capital, with a cash-in-advance restriction on household transactions, and monopolistic firms that set prices one period in advance. The only distortionary policy instruments are the nominal interest rate and the money supply. In this environment it is feasible to undo both the cash-in-advance and price setting restrictions, but not the distortion due to monopolistic competition. We show that it is optimal to follow the Friedman rule, and thus offset the cash-in-advance restriction. We also find that, in general, it is not optimal to undo the price setting restriction, so that a simple criterion of eliminating gaps is not optimal. Sticky prices provide the planner with tools to improve upon a distorted flexible price allocation. Copyright The Review of Economic Studies Limited, 2003.

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Bibliographic Info

Article provided by Wiley Blackwell in its journal Review of Economic Studies.

Volume (Year): 70 (2003)
Issue (Month): 4 (October)
Pages: 699-713

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Handle: RePEc:bla:restud:v:70:y:2003:i:4:p:699-713

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  1. Marvin Goodfriend & Robert King, 1997. "The New Neoclassical Synthesis and the Role of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 231-296 National Bureau of Economic Research, Inc.
  2. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2003. "Optimal Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 825-860.
  3. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Bernardino Adão & Isabel Horta Correia & Pedro Teles, 2005. "The Monetary Transmission Mechanism: is it Relevant for Policy?," Economic Bulletin and Financial Stability Report Articles, Banco de Portugal, Economics and Research Department.
  5. Isabel Correia & Juan Pablo Nicolini & Pedro Teles, 2008. "Optimal fiscal and monetary policy: equivalence results," Staff Report 403, Federal Reserve Bank of Minneapolis.
  6. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  7. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
  8. Ireland, Peter N, 1996. "The Role of Countercyclical Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 104(4), pages 704-23, August.
  9. Charles T. Carlstrom & Timothy S. Fuerst, 1998. "Price-level and interest-rate targeting in a model with sticky prices," Working Paper 9819, Federal Reserve Bank of Cleveland.
  10. Charles T. Carlstrom & Timothy S. Fuerst, 1998. "A Note on the Role of Countercyclical Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 106(4), pages 860-889, August.
  11. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
  12. Marvin Goodfriend & Robert G. King, 2001. "The Case for Price Stability," NBER Working Papers 8423, National Bureau of Economic Research, Inc.
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