Optimal Monetary Policy under Sticky Prices and Sticky Information

A wrong model can lead to a wrong conclusion. The failure to capture inflation dynamics has made the standard New Keynesian framework of monetary policy analysis prone to such a critique. In this paper, we investigate optimal monetary policy using a model that can capture the observed inflation persistence. The model, which we call the dual stickiness model, integrates sticky prices and sticky information. Two main results characterize the optimal policy. First, in the presence of cost-push shocks, a simple elastic price target rule is optimal, regardless of the degree of each stickiness, and regardless of whether the specification of stickiness is fixed-duration or random-duration. Second, the dynamics under the optimal policy in the model are more persistent than those in the models with either of the two types of stickiness. We also evaluate how important it is for the central bank to distinguish the dual stickiness model from an existing alternative, the hybrid New Keynesian model. The results show that, in the presence of error in controlling the output gap, the welfare loss can be huge when the central bank fails to recognize the dual stickiness model as the true model of the economy.