NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Optimal Stabilization Policy When Wages and Prices are Sticky: The Case of a Distorted Steady State

Pierpaolo Benigno, Michael Woodford

NBER Working Paper No. 10839
Issued in October 2004
NBER Program(s):   EFG   ME

Erceg et al. (2000) show that when both wages and prices are sticky, maximization of expected utility is equivalent to minimizing a loss function with three terms, involving measures of the variability of wage inflation, price inflation and the output gap respectively. Here we generalize their analysis, most importantly by not assuming the existence of output and employment subsidies that eliminate the distortions resulting from market power in goods and labor markets, so that the equilibrium level of output under flexible wages and prices would not necessarily be optimal. We show that a quadratic loss function can still be justified that involves the same three terms, albeit with different relative weights and a different definition of the output gap. Many conclusions of Erceg et al. are thus found to apply more generally. However, we argue that in the presence of significant steady-state distortions, simple rules of the kind that they examine are likely to approximate optimal policy less closely than is suggested by their numerical results.

download in pdf format
   (391 K)

email paper

This paper is available as PDF (391 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w10839

Published: Pierpaolo Benigno & Michael Woodford, 2005. "Optimal stabilization policy when wages and prices are sticky: the case of a distorted steady state," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 127-180. citation courtesy of

Users who downloaded this paper also downloaded these:
Benigno and Woodford w10838 Inflation Stabilization and Welfare: The Case of a Distorted Steady State
Benigno and Woodford Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach
Benigno and Woodford w12158 Optimal Inflation Targeting under Alternative Fiscal Regimes
Benigno and Woodford w12672 Linear-Quadratic Approximation of Optimal Policy Problems
Poterba, Rauh, Venti, and Wise w12597 Defined Contribution Plans, Defined Benefit Plans, and the Accumulation of Retirement Wealth
 
Publications
Activities
Meetings
NBER Videos
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us