Working Paper: NBER ID: w10838
Authors: Pierpaolo Benigno; Michael Woodford
Abstract: This paper considers the appropriate stabilization objectives for monetary policy in a microfounded model with staggered price-setting. Rotemberg and Woodford (1997) and Woodford (2002) have shown that under certain conditions, a local approximation to the expected utility of the representative household in a model of this kind is related inversely to the expected discounted value of a conventional quadratic loss function, in which each period's loss is a weighted average of squared deviations of inflation and an output gap measure from their optimal values (zero). However, those derivations rely on an assumption of the existence of an output or employment subsidy that offsets the distortion due to the market power of monopolistically-competitive price-setters, so that the steady state under a zero-inflation policy involves an efficient level of output. Here we show how to dispense with this unappealing assumption, so that a valid linear-quadratic approximation to the optimal policy problem is possible even when the steady state is distorted to an arbitrary extent (allowing for tax distortions as well as market power), and when, as a consequence, it is necessary to take account of the effects of stabilization policy on the average level of output. \n\tWe again obtain a welfare-theoretic loss function that involves both inflation and an appropriately defined output gap, though the degree of distortion of the steady state affects both the weights on the two stabilization objectives and the definition of the welfare-relevant output gap. In the light of these results, we reconsider the conditions under which complete price stability is optimal, and find that they are more restrictive in the case of a distorted steady state. We also consider the conditions under which pure randomization of monetary policy can be welfare-improving, and find that this is possible in the case of a sufficiently distorted steady state, though the parameter values required are probably not empirically realistic.
Keywords: No keywords provided
JEL Codes: D61; E52; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected utility of the representative household (D11) | expected discounted value of a conventional quadratic loss function (J17) |
| effective monetary policy (E52) | stabilization of both inflation and output (E63) |
| cost-push shocks (E31) | complication of effective monetary policy goals (E61) |
| randomization of monetary policy (E52) | welfare improvement under certain circumstances (D60) |
| tax distortions and market power (H31) | affects the definition of the welfare-relevant output gap (D69) |
| tax distortions and market power (H31) | affects weights assigned to inflation and output stabilization in the loss function (E31) |