Monetary Stabilization Policy in a Dynamic Stochastic Menu Cost Model

This paper analyses systematic monetary policy in a dynamic stochastic menu cost model. The main assumptions are that price setters have to pay small adjustment costs in order to equalize actual and optimal prices whereas the central bank can do so costlessly (by adjusting the money supply) but only with a lag. It is shown that a simple (static optimal) policy that fully counteracts all shocks may reduce welfare. The policy reduces the consequences of small shocks but increases the band of inaction of the price setters. This feed-back effect on price setters increases the amount of price rigidity and reduces welfare. In fact, a socially optimal monetary policy may involve a commitment to enhance large shocks.