Optimal Monetary Policy with Staggered Wage and Price Contracts

We formulate an optimizing-agent model in which both labor and product markets exhibit monopolistic competition and staggered nominal contracts. We demonstrate that the household's unconditional expected utility can be expressed in terms of the unconditional variances of the outgap gap, aggregate price inflation, and aggregate wage inflation. Furthermore, when both wages and prices exhibit nominal inertia, monetary policy cannot replicate the Pareto-optimal resource allocation that would occur under completely flexible wages and prices; that is, the model exhibits a policy tradeoff among stabilizing the output gap, the price inflation rate, and the wage inflation rate. We use numerical methods to analyze the properties of optimal monetary policy rules. Finally, we show that strict price-inflation targeting induces substantial welfare losses due to excessive output gap volatility. This contrasts to the near-optimality of interest rate rules that place substantial weight on both the output gap and the inflation rate.