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Optimal Stabilization Policy When Wages and Prices are Sticky: The Case of a Distorted Steady State

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  • Pierpaolo Benigno
  • Michael Woodford

Abstract

Erceg et al. (2000) show that when both wages and prices are sticky, maximization of expected utility is equivalent to minimizing a loss function with three terms, involving measures of the variability of wage inflation, price inflation and the output gap respectively. Here we generalize their analysis, most importantly by not assuming the existence of output and employment subsidies that eliminate the distortions resulting from market power in goods and labor markets, so that the equilibrium level of output under flexible wages and prices would not necessarily be optimal. We show that a quadratic loss function can still be justified that involves the same three terms, albeit with different relative weights and a different definition of the output gap. Many conclusions of Erceg et al. are thus found to apply more generally. However, we argue that in the presence of significant steady-state distortions, simple rules of the kind that they examine are likely to approximate optimal policy less closely than is suggested by their numerical results.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10839.

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Date of creation: Oct 2004
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Publication status: published as Pierpaolo Benigno & Michael Woodford, 2005. "Optimal stabilization policy when wages and prices are sticky: the case of a distorted steady state," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 127-180.
Handle: RePEc:nbr:nberwo:10839

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  1. Jinill Kim & Dale Henderson, 2002. "Inflation Targeting and Nominal Income Growth Targeting: When and Why Are They Suboptimal?," Computing in Economics and Finance 2002 59, Society for Computational Economics.
  2. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," Levine's Bibliography 506439000000000384, UCLA Department of Economics.
  3. 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.
  4. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 277-316.
  5. Marc Giannoni & Michael Woodford, 2004. "Optimal Inflation-Targeting Rules," NBER Chapters, in: The Inflation-Targeting Debate, pages 93-172 National Bureau of Economic Research, Inc.
  6. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  7. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  8. Pierpaolo Benigno & Michael Woodford, 2004. "Inflation stabilization and welfare: The case of a distorted steady state," Discussion Papers 0405-04, Columbia University, Department of Economics.
  9. 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.
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