Gaps and Triangles
In this paper, we derive principles of optimal cyclical monetary policy
in an economy without capital, with a cash-in-advance restriction on household
transactions, and with monopolistic firms that set prices one period in
advance. The only distortionary policy instruments are the nominal interest
rate and the money supply. In this environment, it is feasible to undo
both the cash in advance and the price setting restrictions, but not the
monopolistic competition distortion. We show that it is optimal to follow
the Friedman rule, and thus offset the cash-in-advance restriction. We also
find that, in general, it is not optimal to undo the price setting restriction.
Sticky prices provide the planner with tools to improve upon a distorted
flexible prices allocation.
