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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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Bibliographic Info

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. Devereux, Michael B, 2003. "Exchange Rate Policy and Endogenous Price Flexibility," CEPR Discussion Papers 4121, C.E.P.R. Discussion Papers.
  2. Ozge Senay & Alan Sutherland, 2005. "Can Endogenous Changes in Price Flexibility Alter the Relative Welfare Performance of Exchange Rate Regimes?," NBER Working Papers 11092, National Bureau of Economic Research, Inc.
  3. Henry Siu & Michael B. Devereux, 2004. "State Dependent Pricing and Business Cycle Asymmetries," 2004 Meeting Papers 161, Society for Economic Dynamics.
  4. 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.
  5. Pierpaolo Benigno & Michael Woodford, 2005. "Inflation Stabilization And Welfare: The Case Of A Distorted Steady State," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1185-1236, December.
  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. Robert Lucas & Mike Golosov, 2004. "Menu Costs and Phillips Curves," 2004 Meeting Papers 144, Society for Economic Dynamics.
  8. Dotsey, Michael & King, Robert G., 2005. "Implications of state-dependent pricing for dynamic macroeconomic models," Journal of Monetary Economics, Elsevier, vol. 52(1), pages 213-242, January.
  9. 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.
  10. David Romer, 1989. "Staggered Price Setting with Endogenous Frequency of Adjustment," NBER Working Papers 3134, National Bureau of Economic Research, Inc.
  11. 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.
  12. 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.
  13. 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.
  14. 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.
  15. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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