DP6423 Strategic Complementarities and Optimal Monetary Policy

Author(s): Andrew Levin, J David López-Salido, Tack Yun
Publication Date: August 2007
Keyword(s): firm-specific factors, quasi-kinked demand, welfare analysis
JEL(s): E31, E32, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6423

In this paper, we show that strategic complementarities--such as firm-specific factors or quasi-kinked demand--have crucial implications for the design of monetary policy and for the welfare costs of output and inflation variability. Recent research has mainly used log-linear approximations to analyze the role of these mechanisms in amplifying the real effects of monetary shocks. In contrast, our analysis explicitly considers the nonlinear properties of these mechanisms that are relevant for characterizing the deterministic steady state as well as the second-order approximation of social welfare in the stochastic economy. We demonstrate that firm-specific factors and quasi-kinked demand curves yield markedly different implications for the welfare costs of steady-state inflation and inflation volatility.