Working Paper: CEPR ID: DP14944
Authors: jennifer lao; alireza tahbazsalehi
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 with less sticky upstream suppliers but stickier downstream customers. In a calibrated version of the model, we find that implementing the optimal policy can result in quantitatively meaningful welfare gains.
Keywords: production networks; optimal monetary policy; nominal rigidities; misallocation
JEL Codes: E52; D57
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy conditions (E52) | Ability to implement flexible-price equilibria (D43) |
| Production network and nominal rigidities (E19) | Ability to implement flexible-price equilibria (D43) |
| Technological heterogeneity and input-output linkages (D57) | No monetary policy can achieve first-best allocation (E19) |
| Constrained-efficient policy (D61) | Stabilizes price index (E31) |
| Optimal monetary policy (E63) | Welfare gains (D69) |
| Optimal policy (C61) | Mitigates welfare losses (D69) |
| Nominal rigidities and production network structures (D20) | Constraints on optimal policy (C61) |