Optimal monetary policy, under flexible and sticky prices, and sticky nominal wages are studied in the canonical matching model of the labor market with a working capital channel. A money demand by firms is motivated by the fact that a significant amount of M1 is held by firms. As a result of the working capital, the Ramsey-optimal monetary policy calls for inflation when employment is above the socially efficient level and for deflation when it is below that level. This result holds under flexible wages as well as nominal wage rigidities. In other words, to improve labor market efficiency, deflation is necessary to “grease the wheels of the labor market.” Although there is no relationship between optimal monetary policy and the market tightness under flexible prices, a long-run and mainly negative relationship between the optimal inflation rate and the equilibrium tightness emerges under sticky prices.

How should central banks optimally aggregate sectoral inflation rates in the presence of imperfect labor mobility across sectors? We study this issue in a two-sector New-Keynesian model and show that a lower degree of sectoral labor mobility, ceteris paribus, increases the optimal weight on inflation in a sector that would otherwise receive a lower weight. We analytically and numerically find that, with limited labor mobility, adjustment to asymmetric shocks cannot fully occur through the reallocation of labor, thus putting more pressure on wages, causing inefficient movements in relative prices, and creating scope for central bank’ s intervention. These findings challenge standard central banks’ practice of computing sectoral inflation weights based solely on sector size and unveil a significant role for the degree of sectoral labor mobility to play in the optimal computation. In an extended estimated model of the US economy, featuring customary frictions and shocks, the estimated inflation weights imply a decrease in welfare up to 10% relative to the case of optimal weights.

This paper examines how innovation-led growth affects optimal monetary policy. We consider the Ramsey policy in a New Keynesian model where R&D leads to an expanding variety of intermediate goods and compare the results with those obtained when the expansion occurs exogenously. Positive trend inflation is found to be optimal under both assumptions, but much higher with profit-seeking innovation. Optimal monetary policy must be counter-cyclical in response to both technology and public spending shocks, yet the intensity of the reaction crucially depends on the presence of an R&D sector. However, the small amount of short-run deviations of prices from the non-zero trend inflation observed in response to shocks suggests inflation targeting as a robust policy recommendation.

By developing a class of dynamic stochastic general equilibrium models with nominal rigidities and assuming a two-country currency union with sovereign risk, we show that there is not necessarily a trade-off between the prevention of default risk and stabilizing inflation. Under optimal monetary and fiscal policy, comprising a de facto inflation stabilization policy, the tax rate as an optimal fiscal policy tool plays an important role in stabilizing inflation, although not completely because of the distorted steady state. Changes in the tax rate to minimize welfare costs via stabilizing inflation then improve the fiscal surplus, and because of this and the incompletely stabilized inflation, the default rate does not increase as much.

We analyze the implications of trend growth for optimal monetary policy in the presence of search and matching unemployment. We show that trend growth interacts importantly with the inefficiencies stemming from the labor market. Higher trend growth exacerbates the inefficiencies of the labor market and therefore calls for larger deviations from price stability. Our analysis implies that lower trend growth reduces not only the level but also the optimal volatility of the nominal interest rate.

We consider a New-Keynesian model with financial and labor market frictions where firms borrowing is limited by the enforcement constraint. The wage is set in a bargaining process where the firm's shareholder and worker share the production surplus. As debt service is considered to be a part of production costs, firms borrow to reduce the surplus which allows to lower the wage. We study the model's response to financial shock under two Taylor-type interest rate rules: first one responds to inflation and borrowing, second one to inflation and unemployment. We have found that the second rule delivers better policy in terms of the welfare measure. Additionally, we show that the feedback on unemployment in this rule depends on the extent of workers' bargaining power.

We assume that firms are more risk averse than households and that they manage their risk through a financial sector, which consists of learning and hedging. Firms that learn (by observing demand shocks) face less uncertainty and produce more than firms that hedge (by selling future production at a fixed price). If a policy or parameter change stabilizes the economy, then there is less learning and usually less production. Welfare, however, is usually maximized when the financial sector, which requires inputs but does not directly provide utility or affect production, is smallest. Monetary policy can improve welfare by either taxing learning or subsidizing hedging. If firms are risk averse over nominal profits instead of real profits, then interest rate policy can also improve welfare by stabilizing prices and thus minimizing the size of the financial sector.

We examine optimal monetary policy in a New Keynesian model with unemployment and financial frictions where banks produce loans using equity as collateral. Firms and households demand loans to finance externally a fraction of their flows of expenditures. Our findings show amplifying business-cycle effects of a more rigid loan production technology. In the monetary policy analysis, the optimal rule clearly outperforms a Taylor-type rule. The optimized interest-rate response to the external finance premium turns significantly negative when either banking rigidities are high or when financial shocks are the only source of business cycle fluctuations.

We use robust control to study how a central bank in an economy with imperfect interest rate pass-through conducts monetary policy if it fears that its model could be misspecified. We find that, first, whether robust optimal monetary policy under commitment responds more cautiously or more aggressively depends crucially on the source of shock. Imperfect pass-through amplifies the robust policy. Second, if the central bank is concerned about uncertainty, it dampens volatility in the inflation rate preemptively but accepts higher volatility in the output gap and loan rate. However, for highly sticky loan rates, insurance against model misspecification becomes particularly pricy. Third, if the central bank fears uncertainty only in the IS equation or the loan rate equation, the robust policy shifts its concern for stabilization away from inflation.

This paper uses a dynamic stochastic general equilibrium model of a two-sector small open economy to analyze how the Maastricht criteria modify a fully credible optimal monetary policy in the Economic and Monetary Union accession countries. We show that if the country is not constrained by the criteria, optimal policy should stabilize fluctuations in PPI inflation, in the aggregate output gap, and in the domestic and international terms of trade. The optimal policy constrained permanently by the Maastricht criteria is characterized by reduced variability of the nominal exchange rate, CPI inflation, and the nominal interest rate and by lower optimal targets for CPI inflation and nominal interest rate. This policy results in higher variability and nonzero means for both PPI inflation and output gap, thus leading to additional, but small, welfare costs compared with the unconstrained policy.

This paper reconsiders the monetary policy implications of a model from which a distinction between CPI inflation and PPI inflation arises. More specifically, this paper addresses the policy conclusion by K. Huang and Z. Liu [2005, Inflation targeting: What inflation rate to target, Journal of Monetary Economics 52, 1435–1462], which states that central banks should use an optimal inflation index that gives substantial weight to stabilizing both CPI and PPI. This paper argues that these authors' findings rely on the assumption that producer prices are as sticky as consumer prices and shows that once empirically relevant frequencies of price adjustment are used to calibrate the model, CPI inflation receives substantial weight in the optimal inflation index. Moreover, this rule is remarkably robust to uncertainty regarding the model parameters.

Using a standard open economy DSGE model, it is shown that the timing of asset trade relative to policy decisions has a potentially important impact on the welfare evaluation of monetary policy at the individual-country level. If asset trade in the initial period takes place before the announcement of policy, a national policy maker can choose a policy rule that reduces the work effort of households in the policy maker's country, in the knowledge that consumption is fully insured by optimally chosen international portfolio positions. But if asset trade takes place after the policy announcement, this insurance is absent and households in the policy maker's country bear the full consumption consequences of the chosen policy rule. The welfare incentives faced by national policy makers are very different between the two cases. Numerical examples confirm that asset-market timing has a significant impact on the optimal policy rule.

We build quadratic labor adjustment costs into an otherwise standard New Keynesian model of the business cycle and show that this increases output persistence in a vein similar to that of other models of labor market frictions. Furthermore, we demonstrate the implication of quadratic labor adjustment costs for monetary policy. We show that there is a simple rule determining whether quadratic labor adjustment costs imply a trade-off between stabilizing inflation and output.

This paper characterizes optimal monetary policy in an economy with endogenous firm entry, a cash-in-advance constraint, and preset wages. Firms must make profits to cover entry costs; thus the markup on goods prices is efficient. However, because leisure is not priced at a markup, the consumption–leisure trade-off is distorted. Consequently, the real wage, hours, and production are suboptimally low. Because of the labor requirement for entry, insufficient labor supply also implies that entry is too low. This paper shows that in the absence of fiscal instruments such as labor income subsidies, the optimal monetary policy achieves higher welfare under sticky wages than under flexible wages. The policy maker uses the money supply instrument to raise the real wage—the cost of leisure—above its flexible-wage level, in response to expansionary shocks to productivity and entry costs. This increases labor supply, expanding production and firm entry.

There is common agreement on price inflation stabilization being one of the objectives of monetary policy. But, in an open economy, two alternative measures of inflation coexist: domestic inflation and consumer price inflation. Which of the two should be the target variable? Most of the new open economy macroeconomics (NOEM) literature suggests that the monetary authority should stabilize domestic inflation. This is in sharp contrast with the practice of many inflation-targeting central banks that are using consumer price index (CPI) inflation as target variable. The paper shows that the standard result in the NOEM literature is derived under the simplifying assumption of flexible wages. The inclusion of sticky wages in an otherwise standard small open economy model is shown to rationalize CPI inflation targeting. This conclusion is robust to changes in key parameters, including the trade elasticity.

The Friedman rule states that steady-state welfare is maximized when there is deflation at the real rate of interest. Recent work by Khan, King, and Wolman [Review of Economic Studies 10 (4), 825–860] uses a richer model but still finds deflation optimal. In an otherwise standard New Keynesian model we show that, if households have hyperbolic discounting, small positive rates of inflation can be optimal. In our baseline calibration, the optimal rate of inflation is 2.1% and remains positive across a wide range of calibrations.

Housing is an important component of the consumption basket. Because both rental prices and goods prices are sticky, the literature suggests that optimal monetary policy should stabilize both types of prices, with the optimal weight on rental inflation proportional to the housing expenditure share. In a two-sector DSGE model with sticky rental prices and goods prices, however, we find that the optimal weight on rental inflation in the Taylor rule is small—much smaller than that implied by the housing expenditure share. We show that the asymmetry in policy responses to rent inflation versus goods inflation stems from the asymmetry in factor intensity between the two sectors.

This paper studies how monetary policy should react to oil shocks in a microfounded model with staggered price-setting and oil as an input in a CES production function. In particular, we extend Benigno and Woodford [Journal of the European Economic Association 3 (6) (2005), 1–52] to obtain a second-order approximation to the expected utility of the representative household when the steady state is distorted and the economy is hit by oil price shocks. The main result is that oil price shocks generate an endogenous trade-off between inflation and output stabilization when oil has low substitutability in production. We also find, in contrast to Benigno and Woodford, that this trade-off is reduced, but not eliminated, when we get rid of the effects of monopolistic distortions in the steady state. Moreover, the size of the endogenous “cost-push” shock generated by fluctuations in the oil price increases when it is more difficult to substitute other factors for oil.

This paper examines optimal monetary policy under uncertainty about fundamental parameters of a dynamic stochastic general-equilibrium model. In contrast to previous studies, a microfoundation of the model leads this uncertainty to generate uncertainty not only about the transmission of monetary policy but also about the transmission of shocks and about a social welfare loss function. In the presence of such uncertainty, this paper finds conditions under which optimal discretionary policy responds to shocks more aggressively than in the absence of the uncertainty. These conditions depend crucially on the persistence of shocks and the magnitude of policy multipliers. To obtain the conditions, taking proper account of uncertainty about the transmission of shocks and about the welfare loss function is of crucial importance.

Empirical evidence suggests that the instrument rule describing the interest rate–setting behavior of the Federal Reserve is nonlinear. This paper shows that optimal monetary policy under parameter uncertainty can motivate this pattern. If the central bank is uncertain about the slope of the Phillips curve and follows a min–max strategy to formulate policy, the interest rate reacts more strongly to inflation when inflation is further away from target. The reason is that the worst case the central bank takes into account is endogenous and depends on the inflation rate and the output gap. As inflation increases, the worst-case perception of the Phillips curve slope becomes larger, thus requiring a stronger interest rate adjustment. Empirical evidence supports this form of nonlinearity for post-1982 U.S. data.