Discussion Paper Details

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Title: Optimal Monetary Policy in Production Networks

Author(s): Jennifer La'O and Alireza Tahbaz-Salehi

Publication Date: June 2020

Keyword(s): Misallocation, nominal rigidities, Optimal monetary policy and production networks

Programme Area(s): Monetary Economics and Fluctuations

Abstract: This paper studies the optimal conduct of monetary policy in a multi-sector economy in which firms buy and sell intermediate goods over a production network. We first provide a necessary and sufficient condition for the monetary policy's ability to implement flexible-price equilibria in the presence of nominal rigidities and show that, generically, no monetary policy can implement the first-best allocation. We then characterize the constrained-efficient policy in terms of the economy's production network and the extent and nature of nominal rigidities. Our characterization result yields general principles for the optimal conduct of monetary policy in the presence of input-output linkages: it establishes that optimal policy stabilizes a price index with higher weights assigned to larger, stickier, and more upstream industries, as well as industries with less sticky upstream suppliers but stickier downstream customers. In a calibrated version of the model, we find that implementing the optimal policy can result in quantitatively meaningful welfare gains.

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Bibliographic Reference

La'O, J and Tahbaz-Salehi, A. 2020. 'Optimal Monetary Policy in Production Networks'. London, Centre for Economic Policy Research.