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

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Author Info
Pierpaolo Benigno
Michael Woodford

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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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Handle: RePEc:nbr:nberwo:10839

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Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Michael Woodford & Pierpaolo Benigno, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," 2004 Meeting Papers 481, Society for Economic Dynamics.
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  2. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings, Federal Reserve Bank of Kansas City, pages 277-316. [Downloadable!]
  3. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  4. 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. [Downloadable!]
  5. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," Levine's Bibliography 506439000000000384, UCLA Department of Economics. [Downloadable!]
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  6. Kim, Jinill & Henderson, Dale W., 2005. "Inflation targeting and nominal-income-growth targeting: When and why are they suboptimal?," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1463-1495, November. [Downloadable!] (restricted)
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  7. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October. [Downloadable!] (restricted)
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  8. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Inflation Targeting Rules," NBER Working Papers 9939, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Andrew T. Levin & Alexei Onatski & John C. Williams & Noah Williams, 2005. "Monetary Policy Under Uncertainty in Micro-Founded Macroeconometric Models," NBER Working Papers 11523, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. 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. [Downloadable!]
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  3. Lawrence Christiano & Roberto Motto & Massimo Rostagno, 2007. "Two Reasons Why Money and Credit May be Useful in Monetary Policy," NBER Working Papers 13502, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  4. Montoro Carlos, 2007. "Oil Shocks and Optimal Monetary Policy," Working Papers 2007-010, Banco Central de Reserva del Perú. [Downloadable!]
  5. Benigno, Pierpaolo & Woodford, Michael, 2006. "Linear-Quadratic Approximation of Optimal Policy Problems," CEPR Discussion Papers 5964, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  6. Frederick van der Ploeg, 2005. "Back to Keynes?," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
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  7. Alex Cukierman, 2006. "Central Bank Independence and Monetary Policymaking Institutions: Past, Present, and Future," Working Papers Central Bank of Chile 360, Central Bank of Chile. [Downloadable!]
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  8. Lars E.O. Svensson, 2005. "Targeting versus instrument rules for monetary policy: what is wrong with McCallum and Nelson?," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 613-626. [Downloadable!]
  9. Lars E.O. Svensson, 2004. "Targeting Rules vs. Instrument Rules for Monetary Policy: What is Wrong with McCallum and Nelson?," NBER Working Papers 10747, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  10. Willem H. Buiter, 2006. "The elusive welfare economics of price stability as a monetary policy objective - why New Keynesian central bankers should validate core inflation," Working Paper Series 609, European Central Bank. [Downloadable!]
  11. Matthias Paustian, 2005. "The role of contracting schemes for the welfare costs of nominal rigidities," Computing in Economics and Finance 2005 196, Society for Computational Economics. [Downloadable!]
  12. Bianca De Paoli, 2004. "Monetary Policy and Welfare in a Small Open Economy," CEP Discussion Papers dp0639, Centre for Economic Performance, LSE. [Downloadable!]
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  13. Giovanni Lombardo & Alan Sutherland, 2005. " Computing Second-Order-Accurate Solutions for Rational Expectation Models Using Linear Solution Methods," CDMA Conference Paper Series 0504, Centre for Dynamic Macroeconomic Analysis. [Downloadable!]
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  14. Michel Juillard & Florian Pelgrin, 2007. "Computing Optimal Policy in a Timeless-Perspective: An Application to a Small-Open Economy," Working Papers 07-32, Bank of Canada. [Downloadable!]
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