Working Paper: NBER ID: w7482
Authors: Stephen G. Cecchetti; Erica L. Groshen
Abstract: This paper discusses how optimal monetary policy is affected by differences in the combination of shocks an economy experiences and the rigidities it exhibits. Without both nominal rigidities and economic shocks, monetary policy would be irrelevant. Recognizing this, policymakers increasingly incorporate the understanding gained from new research on rigidities and shocks into both their policy actions and the design of monetary institutions. Specifically, shocks can be predominantly real, affecting relative prices, or primarily nominal, moving the general price level. They may also be big or small, frequent or rare. Similarly, some nominal rigidities are symmetrical, affecting both upward and downward movements equally, while others are asymmetrical, restricting decreases more than increases. After reviewing major trends in the conduct of monetary policy, we describe how the growing theoretical and empirical literature on shocks and rigidities informs three crucial dimensions of monetary policymaking. First, we discuss why trimmed means provide the best measure of core inflation. Second, we outline how rigidities impede policymakers' ability to control inflation. And third, we describe how alternative shock/rigidity combinations create inflation's grease (whereby it improves economic efficiency by speeding adjustment) and sand effects (whereby it distorts price signals) with their contrasting implications for the optimal level of inflation. We conclude by considering some key implications for monetary policy.
Keywords: Inflation; Monetary Policy; Nominal Rigidities
JEL Codes: E31; E58; J30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| nominal rigidities (D50) | measurement of core inflation (E31) |
| nominal rigidities (D50) | monetary policy transmission mechanism (E52) |
| symmetric rigidities and nominal shocks (C54) | optimal inflation (E31) |
| downward rigidities with real shocks (C54) | zero inflation target (E31) |