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Gaps and Triangles

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  • Bernardino Ad�o
  • 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 2003, Wiley-Blackwell.

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Bibliographic Info

Article provided by Oxford University Press in its journal The Review of Economic Studies.

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

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

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  1. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2000. "Optimal monetary policy," Working Paper, Federal Reserve Bank of Richmond 00-10, Federal Reserve Bank of Richmond.
  2. Isabel Horta Correia & Juan Pablo Nicolini & Pedro Teles, 2003. "Optimal Fiscal and Monetary Policy: Equivalence Results," Working Papers, Banco de Portugal, Economics and Research Department w200303, Banco de Portugal, Economics and Research Department.
  3. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 640, Board of Governors of the Federal Reserve System (U.S.).
  4. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, American Economic Association, vol. 78(3), pages 402-17, June.
  5. Bernardino Adao & Isabel Correia & Pedro Teles, 2000. "The Monetary Transmission Mechanism: Is it Relevant for Policy?," Econometric Society World Congress 2000 Contributed Papers, Econometric Society 0967, Econometric Society.
  6. Charles T. Carlstrom & Timothy S. Fuerst, 1998. "A Note on the Role of Countercyclical Monetary Policy," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 106(4), pages 860-889, August.
  7. Marvin Goodfriend & Robert King, 1997. "The New Neoclassical Synthesis and the Role of Monetary Policy," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 1997, Volume 12, pages 231-296 National Bureau of Economic Research, Inc.
  8. Ireland, Peter N, 1996. "The Role of Countercyclical Monetary Policy," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(4), pages 704-23, August.
  9. Marvin Goodfriend & Robert G. King, 2001. "The case for price stability," Working Paper, Federal Reserve Bank of Richmond 01-02, Federal Reserve Bank of Richmond.
  10. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics, Boston College Department of Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
  11. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  12. Charles T. Carlstrom & Timothy S. Fuerst, 1998. "Price-level and interest-rate targeting in a model with sticky prices," Working Paper, Federal Reserve Bank of Cleveland 9819, Federal Reserve Bank of Cleveland.
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