Monetary Policy with Sectoral Trade-offs

We formulate a two-sector New Keynesian economy that features sectoral heterogeneity along three main dimensions: price stickiness, consumption goods durability, and the inter-sectoral trade of input materials. The combination of these factors deeply affects inter-sectoral and intra-sectoral stabilization. In this context, we examine the welfare properties of simple rules that adjust the policy rate in response to the output gap and alternative measures of final goods price inflation. Aggregating durable and non-durable goods prices depending on the relative frequency of sectoral price-setting may induce a severe bias. Due to factor demand linkages, the cost of production in one sector is influenced by price-setting in the other sector of the economy. As a result, measures of aggregate inflation that weigh sectoral price dynamics based on the relative degree of price rigidity do not allow the central bank to keep track of the effective speeds of sectoral price adjustment.