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© Sanjay K. Chugh
287
Summer 2008
Chapter 23
Optimal Monetary Policy with Sticky Prices
We now reconsider the issue of optimal monetary policy, this time in the Rotemberg
stickyprice framework we just finished developing.
We will find that the policy advice
that arises in a stickyprice view of the economy is qualitatively quite different from the
policy advice that arises in a flexibleprice view of the economy.
The work we do in this chapter builds on virtually all of the ideas and concepts we have
laid out so far.
We will rely on the DixitStiglitzRotemberg model of pricesetting firms
subject to menu costs.
Our mode of optimalpolicy analysis will be identical to the
structure by which we analyzed the optimal policy problem in Chapter 17.
As there, we
must first specify the
privatesector equilibrium for any arbitrary policy the
government (the central bank) might choose.
This in itself requires setting up and
solving the optimization problems of the demand and supply sides of the economy; we
have already done most of this work, but
there
are
a
couple
of
new
elements
we
introduce.
Then, as in Chapter 17, in a second step, we determine the policy that
maximizes the representative consumer’s utility. The final step is to compute the actual
optimal policy, which is done by comparing the solution of the optimal policy problem
with the outcome in the privatesector equilibrium; the result is the optimal policy
recommendation.
We once again – because, we continue to maintain, it seems very
natural – adopt the representative consumer’s utility as the welfare criterion according to
which the central bank ranks various policies.
Thus, just as in our earlier analysis of optimal policy, we can think of the policymakers
as sitting “above” the economy, watching how equilibrium unfolds.
We need to make a
slight refinement to this view here, however:
we will think of the policymakers as
watching how a
symmetric equilibrium
unfolds.
Thus, policymakers understand that for
any
given
policy they choose, the private sector (consumers, retail firms, and wholesale
firms) will make optimal choices that will result in
some
symmetric equilibrium.
All of
this bynow quite familiar machinery allows us to continue to think of the optimal policy
problem
as a problem of choosing the
best
equilibrium, where “best equilibrium” means
the one that maximizes the utility of the representative consumer.
Retail Firms
The representative retail firm is again no different from the one we developed in the basic
DixitStiglitz and Rotemberg models:
a retail firm simply “packages” the continuum
[0,1] of differentiated wholesale products and sells the retail consumption basket to
consumers via perfectlycompetitive markets.
As before, the price of retail goods is
determined only through the invisible hand of the market, and the profitmaximizing
choice of any arbitrary wholesale good
j
leads to the demand function for wholesale good
j,
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288
Summer 2008
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This document was uploaded on 11/01/2011 for the course ECON 325 at Maryland.
 Spring '08
 chugh
 Monetary Policy

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