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A Linear Quadratic Approach to Optimal Monetary Policy with Unemployment and Sticky Prices: The Case of a Distorted Steady State

  • Raissi, M.

Ravenna and Walsh (2010) develop a linear quadratic framework for optimal monetary policy analysis in a New Keynesian model featuring search and matching frictions and show that maximization of expected utility of the representative household is equivalent to minimizing a quadratic loss function that consists of inflation, and two appropriately defined gaps involving unemployment and labor market tightness. This paper generalizes their analysis, most importantly by relaxing the Hosios (1990) condition which eliminates the distortions resulting from labor market inefficiencies, such that the equilibrium level of unemployment under flexible prices would not necessarily be optimal. I take account of steady-state distortions using the methodology of Benigno and Woodford (2005) and derive a quadratic loss function that involves the same three terms, albeit with different relative weights and definitions for unemployment- and labor market tightness gaps. I evaluate the resulting loss function subject to a simple set of log-linearized equilibrium relationships and perform policy analysis. The key result of the paper is that search externalities give rise to an endogenous cost push term in the new Keynesian Phillips curve, suggesting a case against complete price stability as the only goal of monetary policy, because there is now a trade-off between stabilizing inflation and reducing inefficient unemployment fluctuations. Transitory movements of inflation in this environment helps job creation and hence prevents excessive volatility of unemployment.

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Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 1146.

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Date of creation: 21 Jul 2011
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Handle: RePEc:cam:camdae:1146
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  1. Mark Gertler & Antonella Trigari, 2009. "Unemployment Fluctuations with Staggered Nash Wage Bargaining," Journal of Political Economy, University of Chicago Press, vol. 117(1), pages 38-86, 02.
  2. Federico Ravenna & Carl E. Walsh, 2009. "The welfare consequences of monetary policy," Working Paper Series 2009-12, Federal Reserve Bank of San Francisco.
  3. Walsh, Carl E., 2003. "Labor Market Search, Sticky Prices, and Interest Rate Policies," Santa Cruz Department of Economics, Working Paper Series qt6tg550dv, Department of Economics, UC Santa Cruz.
  4. Wouter J. den Haan & Garey Ramey & Joel Watson, 1997. "Job Destruction and Propagation of Shocks," NBER Working Papers 6275, National Bureau of Economic Research, Inc.
  5. Olivier Blanchard & Jordi Galí, 2007. "Real Wage Rigidities and the New Keynesian Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(s1), pages 35-65, 02.
  6. Sala, Luca & Söderström, Ulf & Trigari, Antonella, 2008. "Monetary Policy Under Uncertainty in an Estimated Model with Labour Market Frictions," CEPR Discussion Papers 6826, C.E.P.R. Discussion Papers.
  7. Michael Woodford & Pierpaolo Benigno, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," 2004 Meeting Papers 481, Society for Economic Dynamics.
  8. Marcus Hagedorn & Iourii Manovskii, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies Revisited," 2005 Meeting Papers 460, Society for Economic Dynamics.
  9. Thomas, Carlos, 2008. "Search and matching frictions and optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 55(5), pages 936-956, July.
  10. Simon Burgess & Helene Turon, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies – A Comment," Bristol Economics Discussion Papers 05/573, Department of Economics, University of Bristol, UK.
  11. 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.
  12. Mark Gertler & Luca Sala & Antonella Trigari, 2008. "An Estimated Monetary DSGE Model with Unemployment and Staggered Nominal Wage Bargaining," Working Papers 341, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  13. Ravenna, Federico & Walsh, Carl E., 2008. "Vacancies, unemployment, and the Phillips curve," European Economic Review, Elsevier, vol. 52(8), pages 1494-1521, November.
  14. Faia, Ester, 2009. "Ramsey monetary policy with labor market frictions," Journal of Monetary Economics, Elsevier, vol. 56(4), pages 570-581, May.
  15. Robert Shimer, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies," American Economic Review, American Economic Association, vol. 95(1), pages 25-49, March.
  16. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  17. Faia, Ester, 2008. "Comments on: "Search and matching frictions and optimal monetary policy"," Journal of Monetary Economics, Elsevier, vol. 55(5), pages 957-960, July.
  18. Oliver Jean Blanchard & Peter Diamond, 1989. "The Beveridge Curve," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 20(1), pages 1-76.
  19. Schorfheide, Frank, 2008. "Comment on: "Monetary policy under uncertainty in an estimated model with labor market frictions" by Luca Sala, Ulf Söderström, and Antonella Trigari," Journal of Monetary Economics, Elsevier, vol. 55(5), pages 1007-1010, July.
  20. Arthur J. Hosios, 1990. "On The Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Oxford University Press, vol. 57(2), pages 279-298.
  21. Federico Ravenna & Carl E. Walsh, 2011. "Welfare-Based Optimal Monetary Policy with Unemployment and Sticky Prices: A Linear-Quadratic Framework," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(2), pages 130-62, April.
  22. Raj Chetty, 2003. "A New Method of Estimating Risk Aversion," NBER Working Papers 9988, National Bureau of Economic Research, Inc.
  23. Merz, Monika, 1995. "Search in the labor market and the real business cycle," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 269-300, November.
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