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A Linear Quadratic Approach to Optimal Monetary Policy with Unemployment and Sticky Prices: The Case of a Distorted Steady State

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  • Raissi, M.

Abstract

Ravenna and Walsh (2010) develop a linear quadratic framework for optimal monetary policy analysis in a New Keynesian model featuring search and matching frictions and show that maximization of expected utility of the representative household is equivalent to minimizing a quadratic loss function that consists of inflation, and two appropriately defined gaps involving unemployment and labor market tightness. This paper generalizes their analysis, most importantly by relaxing the Hosios (1990) condition which eliminates the distortions resulting from labor market inefficiencies, such that the equilibrium level of unemployment under flexible prices would not necessarily be optimal. I take account of steady-state distortions using the methodology of Benigno and Woodford (2005) and derive a quadratic loss function that involves the same three terms, albeit with different relative weights and definitions for unemployment- and labor market tightness gaps. I evaluate the resulting loss function subject to a simple set of log-linearized equilibrium relationships and perform policy analysis. The key result of the paper is that search externalities give rise to an endogenous cost push term in the new Keynesian Phillips curve, suggesting a case against complete price stability as the only goal of monetary policy, because there is now a trade-off between stabilizing inflation and reducing inefficient unemployment fluctuations. Transitory movements of inflation in this environment helps job creation and hence prevents excessive volatility of unemployment.

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Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 1146.

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Date of creation: 21 Jul 2011
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Handle: RePEc:cam:camdae:1146

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  1. Oliver Jean Blanchard & Peter Diamond, 1989. "The Beveridge Curve," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 20(1), pages 1-76.
  2. Michael Woodford & Pierpaolo Benigno, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," 2004 Meeting Papers 481, Society for Economic Dynamics.
  3. Carlos Thomas, 2006. "Search and Matching Frictions and Optimal Monetary Policy," CEP Discussion Papers dp0743, Centre for Economic Performance, LSE.
  4. Olivier Blanchard & Jordi Galí, 2007. "Real Wage Rigidities and the New Keynesian Model," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 39(s1), pages 35-65, 02.
  5. Marcus Hagedorn & Iourii Manovskii, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies Revisited," 2005 Meeting Papers, Society for Economic Dynamics 460, Society for Economic Dynamics.
  6. Faia, Ester, 2009. "Ramsey monetary policy with labor market frictions," Journal of Monetary Economics, Elsevier, Elsevier, vol. 56(4), pages 570-581, May.
  7. Mark Gertler & Antonella Trigari, 2006. "Unemployment Fluctuations with Staggered Nash Wage Bargaining," Computing in Economics and Finance 2006, Society for Computational Economics 525, Society for Computational Economics.
  8. Schorfheide, Frank, 2008. "Comment on: "Monetary policy under uncertainty in an estimated model with labor market frictions" by Luca Sala, Ulf Söderström, and Antonella Trigari," Journal of Monetary Economics, Elsevier, Elsevier, vol. 55(5), pages 1007-1010, July.
  9. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
  10. Federico Ravenna & Carl E. Walsh, 2009. "Welfare-based optimal monetary policy with unemployment and sticky prices: a linear-quadratic framework," Working Paper Series, Federal Reserve Bank of San Francisco 2009-15, Federal Reserve Bank of San Francisco.
  11. Faia, Ester, 2008. "Comments on: "Search and matching frictions and optimal monetary policy"," Journal of Monetary Economics, Elsevier, Elsevier, vol. 55(5), pages 957-960, July.
  12. Sala, Luca & Söderström, Ulf & Trigari, Antonella, 2008. "Monetary Policy Under Uncertainty in an Estimated Model with Labour Market Frictions," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6826, C.E.P.R. Discussion Papers.
  13. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
  14. Walsh, Carl E., 2003. "Labor Market Search, Sticky Prices, and Interest Rate Policies," Santa Cruz Center for International Economics, Working Paper Series, Center for International Economics, UC Santa Cruz qt6tg550dv, Center for International Economics, UC Santa Cruz.
  15. Luca Sala & Antonella Trigari & Mark Gertler, 2007. "An Estimated Monetary DSGE Model with Unemployment and Staggered Nominal Wage Bargaining," 2007 Meeting Papers, Society for Economic Dynamics 353, Society for Economic Dynamics.
  16. Garey Ramey & Wouter J. den Haan & Joel Watson, 2000. "Job Destruction and Propagation of Shocks," American Economic Review, American Economic Association, American Economic Association, vol. 90(3), pages 482-498, June.
  17. Carl Walsh & Federico Ravenna, 2007. "Vacancies, Unemployment, and the Phillips Curve," 2007 Meeting Papers, Society for Economic Dynamics 1014, Society for Economic Dynamics.
  18. Federico Ravenna & Carl E. Walsh, 2009. "The welfare consequences of monetary policy," Working Paper Series, Federal Reserve Bank of San Francisco 2009-12, Federal Reserve Bank of San Francisco.
  19. Hosios, Arthur J, 1990. "On the Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 57(2), pages 279-98, April.
  20. Raj Chetty, 2006. "A New Method of Estimating Risk Aversion," American Economic Review, American Economic Association, American Economic Association, vol. 96(5), pages 1821-1834, December.
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  22. Merz, Monika, 1995. "Search in the labor market and the real business cycle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 36(2), pages 269-300, November.
  23. Simon Burgess & Helene Turon, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies – A Comment," Bristol Economics Discussion Papers 05/573, Department of Economics, University of Bristol, UK.
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Cited by:
  1. Paul Cashin & Kamiar Mohaddes & Mehdi Raissi & Maziar Raissi, 2012. "The Differential Effects of Oil Demand and Supply Shocks on the Global Economy," IMF Working Papers 12/253, International Monetary Fund.

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