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Strategic Complementarities and Optimal Monetary Policy

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  • Andrew T. Levin
  • J. David Lopez-Salido
  • Tack Yun

Abstract

In this paper, we show that strategic complementarities–such as firm-specific factors or quasikinked demand–have crucial implications for the design of monetary policy and for the welfare costs of output and inflation variability. Recent research has mainly used log-linear approximations to analyze the role of these mechanisms in amplifying the real effects of monetary shocks. In contrast, our analysis explicitly considers the nonlinear properties of these mechanisms that are relevant for characterizing the deterministic steady state as well as the second-order approximation of social welfare in the stochastic economy. We demonstrate that firm-specific factors and quasi-kinked demand curves yield markedly different implications for the welfare costs of steady-state inflation and inflation volatility, and we show that these considerations have dramatic consequences in assessing the relative price distortions associated with the Great Inflation of 1965-1979.

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Bibliographic Info

Paper provided by Kiel Institute for the World Economy in its series Kiel Working Papers with number 1355.

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Length: 44 pages
Date of creation: Jun 2007
Date of revision:
Handle: RePEc:kie:kieliw:1355

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Keywords: firm-specific factors; quasi-kinked demand; welfare analysis;

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References

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Citations

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Cited by:
  1. Andrew T. Levin, 2008. "Commentary on "Optimal monetary policy under uncertainty: a Markov jump-linear-quadratic approach"," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 301-306.
  2. Argia M. Sbordone, 2008. "Globalization and inflation dynamics: the impact of increased competition," Staff Reports 324, Federal Reserve Bank of New York.
  3. Fujiwara, Ippei & Teranishi, Yuki, 2008. "A dynamic new Keynesian life-cycle model: Societal aging, demographics, and monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 32(8), pages 2398-2427, August.
  4. Amano, Robert & Moran, Kevin & Murchison, Stephen & Rennison, Andrew, 2009. "Trend inflation, wage and price rigidities, and productivity growth," Journal of Monetary Economics, Elsevier, vol. 56(3), pages 353-364, April.
  5. Juergen von Hagen, 2008. "The Role of Contracting Schemes for Assessing the Welfare Costs of Nominal Rigidities," 2008 Meeting Papers 827, Society for Economic Dynamics.
  6. Andrew T. Levin & J. David López-Salido & Edward Nelson & Tack Yun, 2008. "Macroeconometric equivalence, microeconomic dissonance, and the design of monetary policy," Working Papers 2008-035, Federal Reserve Bank of St. Louis.
  7. Furlanetto, Francesco & Seneca, Martin, 2014. "Investment shocks and consumption," European Economic Review, Elsevier, vol. 66(C), pages 111-126.
  8. Tack Yun & Andrew Levin, 2011. "Reconsidering the Microeconomic Foundations of Price-Setting Behavior," 2011 Meeting Papers 424, Society for Economic Dynamics.
  9. Michael K. Johnston, 2009. "Real and Nominal Frictions within the Firm: How Lumpy Investment Matters for Price Adjustment," Working Papers 09-36, Bank of Canada.
  10. Riggi, Marianna & Tancioni, Massimiliano, 2010. "Nominal vs real wage rigidities in New Keynesian models with hiring costs: A Bayesian evaluation," Journal of Economic Dynamics and Control, Elsevier, vol. 34(7), pages 1305-1324, July.

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