Optimal Monetary Policy in Production Networks

54 Pages Posted: 12 Dec 2019 Last revised: 24 Sep 2020

Date Written: November 16, 2019

Abstract

This paper studies the optimal conduct of monetary policy in a multi-sector economy in which firms buy and sell intermediate goods over a production network. We first provide a necessary and sufficient condition for the monetary policy’s ability to implement flexible-price equilibria in the presence of nominal rigidities and show that, generically, no monetary policy can implement the first-best allocation. We then characterize the constrained-efficient policy in terms of the economy’s production network and the extent and nature of nominal rigidities. Our characterization result yields general principles for the optimal conduct of monetary policy in the presence of input-output linkages: it establishes that optimal policy stabilizes a price index with higher weights assigned to larger, stickier, and more upstream industries, as well as industries that face stronger strategic complementarities in price setting.

Keywords: monetary policy, production networks, nominal rigidities, misallocation

Suggested Citation

La’O, Jennifer and Tahbaz-Salehi, Alireza, Optimal Monetary Policy in Production Networks (November 16, 2019). Available at SSRN: https://ssrn.com/abstract=3488415 or http://dx.doi.org/10.2139/ssrn.3488415

Jennifer La’O

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

Alireza Tahbaz-Salehi (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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