How Do Nominal and Real Rigidities Interact? A Tale of the Second Best

This paper analyses the importance of real wage rigidities, in particular through their interaction with price stickiness, for optimal monetary policy in a calibrated small open economy DSGE model including oil in production and consumption. Blanchard and Galiacute; (2007a) show real rigidities to introduce a trade-off between stabilising inflation and the welfare-relevant output gap. The present paper complements their findings by showing that the welfare cost of real rigidities can be substantial compared to nominal frictions. In a typical quot;tale of the second bestquot;, we also show that in the presence of real wage rigidities, price stickiness can be welfare-enhancing