Gaps and Triangles

Abstract

In this paper, we derive principles of optimal cyclical monetary policy in an economy without capital, with a cash-in-advance restriction on household transactions, and with monopolistic firms that set prices one period in advance. The only distortionary policy instruments are the nominal interest rate and the money supply. In this environment, it is feasible to undo both the cash in advance and the price setting restrictions, but not the monopolistic competition distortion. We show that it is optimal to follow the Friedman rule, and thus offset the cash-in-advance restriction. We also find that, in general, it is not optimal to undo the price setting restriction. Sticky prices provide the planner with tools to improve upon a distorted flexible prices allocation.

Keywords: optimal cyclical monetary policy, Friedman rule, prices set in advance

JEL Classification: E31, E41, E58, E62