Kiel Working Papers, Kiel Institute for World Economics
No 1355:
Strategic Complementarities and Optimal Monetary Policy
Andrew T. Levin, J. David Lopez-Salido and Tack Yun
Abstract: In this paper, we show that strategic
complementarities–such as firm-specific factors or quasikinked 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, and we show that these considerations
have dramatic consequences in assessing the relative price distortions
associated with the Great Inflation of 1965-1979.
Keywords: firm-specific factors, quasi-kinked demand, welfare analysis; (follow links to similar papers)
JEL-Codes: E31,; E32,; E52; (follow links to similar papers)
44 pages, June 2007
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