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Optimal Fiscal and Monetary Policy with Sticky Wages and Sticky Prices

In a recent strand of the Ramsey literature on optimal fiscal and monetary policy, Schmitt-Grohe and Uribe (2004b) and Siu (2004) have found that sticky product prices makes the volatility of Ramsey inflation quite small. This result contrasts with the strikingly high inflation volatility discovered by Chari, Christiano, and Kehoe (1991) in an environment with flexible prices. Given recent renewed attention to the importance of stickiness in nominal wages, a natural question is to what degree does low volatility of Ramsey inflation arise in a model featuring sticky wages, either instead of or in addition to sticky prices.

In this paper, we address this question in a well understood Ramsey environment. Our main result is that sticky wages alone dampen inflation volatility to a similar quantitative degree as sticky prices alone in the face of government spending shocks. That is, consumer price stability characterizes optimal monetary policy if wages are sticky even if product prices are fully flexible.

Inflation volatility is high in the baseline model of Chari, Christiano, and Kehoe (1991) because surprise movements in the price level allow the government to synthesize real state-contingent debt from nominally risk-free government bonds. Surprise inflation thus serves as a non-distortionary instrument to finance innovations in government spending, and so is preferred by the Ramsey planner to changes in distorting proportional taxes.

As a prescriptive matter for central bankers, however, the optimality of highly volatile inflation seems peculiar. This prediction turns out to depend crucially on Chari, Christiano, and Kehoe’s (1991) assumption of zero allocative effects of surprise inflation, due to fully-flexible prices and wages. In contrast, central bankers typically think of the economy as featuring nominal rigidities, which entail costs of surprise movements in the price level.

Optimal Fiscal and Monetary Policy with Sticky Wages and Sticky Prices