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

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. ∗We would like to thank Bob King and Andy Levin for helpful comments, and the National Science Foundation for research support through a grant to the NBER. In a seminal paper, Chris Erceg, Dale Henderson, and Andy Levin (2000) analyzed the consequences for optimal monetary policy of the stickiness of both wages and prices. A key contribution of their paper was the demonstration that the expected utility of the representative household in their model could be approximated by an objective with three terms, involving measures of the variability of wage inflation, price inflation and the output gap respectively. While wage-inflation stabilization has not commonly been included among the assumed objectives of monetary policy in studies that lack welfare-theoretic foundations, Erceg et al. showed that in the context of their model (with Calvo-style staggering of both wageand price-setting decisions), such an objective is appropriate in the case that wages as well as prices are sticky. This is because variability of the rate of growth of nominal wages implies misalignment of wages that are adjusted at different times, and hence inefficient utilization of different types of labor. They showed furthermore that the existence of this additional stabilization objective implies that a policy aimed solely at inflation stabilization (a strict inflation target) is not generally optimal, and may be quite undesirable. Instead, their numerical analysis suggests that one can do quite well by targeting an appropriately chosen weighted average of wage and price inflation, with a greater relative weight on wage inflation the greater the relative stickiness of wages. Here we reexamine the issues raised by Erceg et al. in a slightly more general setting. Following Rotemberg and Woodford (1997), Erceg et al. assume the existence of an output subsidy in order to eliminate the distortion resulting from the market power of the suppliers of differentiated goods, and a similar employment sub-