We formulate an optimizing-agent model in which both labor and product markets exhibit
monopolistic competition and staggered nominal contracts. The unconditional expectation of
average household utility can be expressed in terms of the unconditional variances of the output
gap, price inflation, and wage inflation. Monetary policy cannot replicate the Pareto-optimal
equilibrium that would occur under completely flexible wages and prices; that is, the model
exhibits a tradeoff between stabilizing the output gap, price inflation, and wage inflation. The
Pareto optimum is attainable only if either wages or prices are completely flexible. For
reasonable calibrations of the model, we characterize the optimal policy rule. Furthermore, strict
price inflation targeting is clearly suboptimal, whereas rules that also respond to either the output
gap or wage inflation are nearly optimal.
Full paper (574 KB PDF)
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Last update: July 19, 2001