Optimal Monetary Policy Under Menu Costs - Basil Halperin

We analytically characterize optimal monetary policy in a multisector economy with menu costs and show that inflation and output should move inversely following sectoral shocks. That is, after negative productivity shocks, inflation should be allowed to rise, and vice versa. In a baseline parameterization, optimal policy stabilizes nominal wages. This nominal wage targeting contrasts with inflation targeting, the optimal policy prescribed by the textbook New Keynesian model in which firms are permitted to adjust their prices only randomly and exogenously. The key intuition is that stabilizing inflation causes shocks to spill over across sectors, needlessly increasing the number of firms that must pay the fixed menu cost of price adjustment compared to optimal policy. Finally, we show in a quantitative model that, following a sectoral shock, nominal wage targeting reduces the welfare loss arising from menu costs by 81% compared to inflation targeting.

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