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Endogenous Price Flexibility and Optimal Monetary Policy

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  • Ozge Senay
  • Alan Sutherland

Abstract

Much of the literature on optimal monetary policy uses models in which the degree of nominal price flexibility is exogenous. There are, however, good reasons to suppose that the degree of price flexibility adjusts endogenously to changes in monetary conditions. This paper extends the standard New Keynesian model to incorporate an endogenous degree of price flexibility. The model shows that endo?genising the degree of price flexibility tends to shift optimal monetary policy towards complete inflation stabilisation, even when shocks take the form of cost-push distur?bances. This contrasts with the standard result obtained in models with exogenous price flexibility, which show that optimal monetary policy should allow some degree of inflation volatility in order to stabilise the welfare-relevant output gap.

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Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Working Paper Series with number 201007.

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Date of creation: 15 Feb 2010
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Handle: RePEc:san:cdmawp:1007

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Keywords: Welfare; Endogenous Price Flexibility; Optimal Monetary Policy.;

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  1. Mikhail Golosov & Robert E. Lucas Jr., 2007. "Menu Costs and Phillips Curves," Journal of Political Economy, University of Chicago Press, vol. 115, pages 171-199.
  2. 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.
  3. Levin, Andrew & Yun, Tack, 2007. "Reconsidering the natural rate hypothesis in a New Keynesian framework," Journal of Monetary Economics, Elsevier, vol. 54(5), pages 1344-1365, July.
  4. Michael Dotsey & Robert G. King, 2005. "Implications of state-dependent pricing for dynamic macroeconomic models," Working Papers 05-2, Federal Reserve Bank of Philadelphia.
  5. David Romer, 1989. "Staggered Price Setting with Endogenous Frequency of Adjustment," NBER Working Papers 3134, National Bureau of Economic Research, Inc.
  6. Pierpaolo Benigno & Michael Woodford, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," NBER Working Papers 10838, National Bureau of Economic Research, Inc.
  7. Devereux, Michael B, 2003. "Exchange Rate Policy and Endogenous Price Flexibility," CEPR Discussion Papers 4121, C.E.P.R. Discussion Papers.
  8. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  9. Henry Siu & Michael B. Devereux, 2004. "State Dependent Pricing and Business Cycle Asymmetries," 2004 Meeting Papers 161, Society for Economic Dynamics.
  10. Yetman, James, 2003. "Fixed prices versus predetermined prices and the equilibrium probability of price adjustment," Economics Letters, Elsevier, vol. 80(3), pages 421-427, September.
  11. Kiley, Michael T, 2000. "Endogenous Price Stickiness and Business Cycle Persistence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(1), pages 28-53, February.
  12. Devereux, Michael B. & Yetman, James, 2002. "Menu costs and the long-run output-inflation trade-off," Economics Letters, Elsevier, vol. 76(1), pages 95-100, June.
  13. Lars Calmfors & Asa Johansson, 2006. "Nominal Wage Flexibility, Wage Indexation and Monetary Union," Economic Journal, Royal Economic Society, vol. 116(508), pages 283-308, 01.
  14. Michael Dotsey & Robert G. King & Alexander L. Wolman, 1999. "State-Dependent Pricing And The General Equilibrium Dynamics Of Money And Output," The Quarterly Journal of Economics, MIT Press, vol. 114(2), pages 655-690, May.
  15. Ozge Senay & Alan Sutherland, 2006. "Can Endogenous Changes in Price Flexibility Alter the Relative Welfare Performance of Exchange Rate Regimes?," NBER Chapters, in: NBER International Seminar on Macroeconomics 2004, pages 371-412 National Bureau of Economic Research, Inc.
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