Perm solves best---monetary policy is ineffective absent fiscal interventions

Federico Ravenna and Carl E. Walsh, “The Welfare Consequences of Monetary Policy and the Role of the Labor Market: a Tax Interpretation,” Federal Reserve Bank of San Francisco, April 2009, https://www.frbsf.org/economic-research/publications/working-papers/2009/12/

Our results can be summarized as follows. In our model, it is feasible for monetary policy to completely undo the price setting restriction. However, because the incentive to search responds to movements in the markup, but not to movements in nominal variables, we find that the policymaker can achieve higher welfare in the economy with staggered price setting rather than in one where price setting is unconstrained and one of the distortions relative to the first best is absent.

At the same time, while the cost of the search inefficiency is large, the welfare attained by the optimal policy deviates very little from the one achieved under flexible prices. In practice, the policymaker finds little incentive in trying to correct for the search inefficiency, and to deviate from a policy of price stability. Monetary policy is of limited effectiveness because it works through the retail sector markup, which simultaneously affects all of the distortions present in the economy, and because Nash bargaining implies low volatility of employment. In this sense, our result is the welfare implication of the Shimer’s (2004) puzzle. Yet, introducing real wage rigidity does not, in itself, modify this result. This is in stark contrast with models including staggered wage and price contracts (Erceg, Henderson and Levin, 2000, Thomas, 2008). It is only with a wage norm fixed at a level very different from the efficient steady state that deviations from price stability yield high return in terms of welfare, and the trade-off faced by the policymaker can be favorably exploited to increase search efficiency. In this case, there exist gains from accounting for the labor market’s structure in selecting monetary policy, even without introducing an explicit cost of wage dispersion. Additionally, in our model the hours margin plays a minor role in the welfare results. We conjecture that the explicit introduction of overtime labor would change this result.

Monetary policy interacts in complex way with fiscal and labor market policies. We find that the welfare gain of deviation from price stability is larger, the more volatile are labor market flows over the business cycle. Higher firing and hiring costs, as in the EU, make price stability a relatively closer approximation to the optimal policy. The same labor market characteristics that lower steady-state employment, and leave more to be gained from long-term policy intervention, make cyclical monetary policy less effective. How fiscal and monetary policies should coordinate once the distortions from the financing of taxes and subsidies is taken into account is a question left open for future research.