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State-Dependent Pricing and Optimal Monetary Policy

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  • Lie, Denny
Abstract
This paper studies optimal monetary policy under precommitment in a state-dependent pricing (SDP) environment, in contrast to the standard assumption of time-dependent pricing(TDP). I show that the endogenous timing of price adjustment under SDP importantly alters the policy tradeoffs faced by the monetary authority, due to lower cost of inflation variation on the relative-price distortion. It is thus desirable under SDP for the monetary authority to put less weight on inflation stabilization, relative to other stabilization goals. The optimal Ramsey policy under SDP delivers a 24 percent higher standard deviation of inflation, but with 26 percent and 6 percent lower standard deviations of output gap and nominal interest rate, respectively. Within a simple, Taylor-like policy rule, the change in the policy tradeoffs is manifested in higher feedback response coefficients on the output gap and the lagged nominal interest rate deviation under SDP. Additionally, this paper studies the optimal policy start-up problem related to the cost of adopting the timeless perspective policy instead of the true Ramsey policy. The SDP assumption leads to different start-up dynamics compared to the dynamics under the TDP assumption in several important ways. In particular, the change in the policy tradeoffs gives rise to much higher start-up inflation under SDP.

Suggested Citation

  • Lie, Denny, 2015. "State-Dependent Pricing and Optimal Monetary Policy," Working Papers 2015-09, University of Sydney, School of Economics.
    • Handle: RePEc:syd:wpaper:2015-09
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    References listed on IDEAS

    as
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    Cited by:

    1. Anton Nakov & Carlos Thomas, 2014. "Optimal Monetary Policy with State-Dependent Pricing," International Journal of Central Banking, International Journal of Central Banking, vol. 10(3), pages 49-94, September.
    2. Yunjong Eo & Denny Lie, 2020. "The Role of Inflation Target Adjustment in Stabilization Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 52(8), pages 2007-2052, December.
    3. Lie, Denny, 2021. "Implications of state-dependent pricing for DSGE model-based policy analysis in Indonesia," Economic Analysis and Policy, Elsevier, vol. 71(C), pages 532-552.

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    Keywords

    optimal monetary policy; state-dependent pricing; start-up problem; policy tradeoff; Ramsey policy; simple policy rule;
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