Optimal Monetary Policy with State-Dependent Pricing

33 Pages Posted: 16 Nov 2011

See all articles by Carlos Thomas

Carlos Thomas

Banco de España

Anton Nakov

European Central Bank (ECB); CEPR

Multiple version iconThere are 4 versions of this paper

Date Written: November 2, 2011

Abstract

In an abstract economic model, we study optimal monetary policy from the timeless perspective under a general state-dependent pricing framework. We find that when firms are monopolistic competitors subject to idiosyncratic menu cost shocks, households have isoelastic preferences, and there is no government spending, strict price stability is optimal both in the long run and in response to aggregate shocks. Key to this finding is an "envelope" property: At zero inflation, a marginal increase in the rate of inflation has no effect on firms' profits and therefore it has no effect on the probability of price adjustment. Our results lend support to more informal statements about the suitability of the Calvo model for studying optimal monetary policy despite its apparent conflict with the Lucas critique. We offer an analytic solution that does not require local approximation or efficiency of the steady state.

Keywords: monetary policy, state-dependent pricing, monopolistic competition

JEL Classification: E31

Suggested Citation

Thomas, Carlos and Nakov, Anton A., Optimal Monetary Policy with State-Dependent Pricing (November 2, 2011). FEDS Working Paper No. 2011-48, Available at SSRN: https://ssrn.com/abstract=1960160 or http://dx.doi.org/10.2139/ssrn.1960160

Carlos Thomas (Contact Author)

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

HOME PAGE: http://www.bde.es

Anton A. Nakov

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

CEPR ( email )

London
United Kingdom

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