Optimal Stabilization Policy When Wages and Prices are Sticky: The Case of a Distorted Steady State

CEPR Discussion Paper No. 4740

77 Pages Posted: 31 Jan 2005

See all articles by Pierpaolo Benigno

Pierpaolo Benigno

University of Bern - Department of Economics

Michael Woodford

Columbia University, Graduate School of Arts and Sciences, Department of Economics

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Date Written: November 2004

Abstract

Erceg et al. (2000) show that when both wages and prices are sticky, maximization of expected utility is equivalent to minimizing a loss function with three terms, involving measures of the variability of wage inflation, price inflation and the output gap respectively. Here we generalize their analysis, most importantly by not assuming the existence of output and employment subsidies that eliminate the distortions resulting from market power in goods and labor markets, so that the equilibrium level of output under flexible wages and prices would not necessarily be optimal. We show that a quadratic loss function can still be justified that involves the same three terms, albeit with different relative weights and a different definition of the output gap. Many conclusions of Erceg et al. are thus found to apply more generally. We argue, however, that in the presence of significant steady-state distortions, simple rules of the kind that they examine are likely to approximate optimal policy less closely than is suggested by their numerical results.

Keywords: Optimal monetary policy, sticky prices, sticky wages

JEL Classification: E52, E61

Suggested Citation

Benigno, Pierpaolo and Woodford, Michael, Optimal Stabilization Policy When Wages and Prices are Sticky: The Case of a Distorted Steady State (November 2004). CEPR Discussion Paper No. 4740, Available at SSRN: https://ssrn.com/abstract=654483

Pierpaolo Benigno (Contact Author)

University of Bern - Department of Economics ( email )

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Bern, CH-3001
Switzerland

Michael Woodford

Columbia University, Graduate School of Arts and Sciences, Department of Economics ( email )

420 W. 118th Street
New York, NY 10027
United States