Nominal frictions, relative price adjustment, and the limits to monetary policy.

There are two broad classes of sticky-price models that have become popular in recent years. In the first class, prices adjust infrequently by assumption (so-called time-dependent models) and in the second class prices adjust infrequently because there is assumed to be a fixed cost of price adjustment (so-called state-dependent models). In both types of models it is common to assume that there are many goods, each produced with identical technologies. Consumers have a preference for variety, but their preferences treat all goods symmetrically. These assumptions mean that it is efficient for all goods to be produced in the same quantities. For that to happen, all goods must sell for the same price at any point in time. Assuming that price adjustment is staggered (as opposed to synchronized), the prices of all goods must be constant over time in order for all goods to be produced in the same quantities. If the aggregate price level were changing over time--even at a constant rate--then with staggered price adjustment prices would necessarily differ across goods.

If there are multiple sectors that possess changing relative technologies or that face changing relative demand conditions (because consumers' preferences are changing across goods), then in general it will no longer be efficient to produce all the goods in the same quantities. Equating marginal rates of transformation to marginal rates of substitution may require relative prices to change over time. These efficient changes in relative prices across sectors require nominal prices to change within sectors. With frictions in nominal price adjustment, nominal price changes bring with them costly misallocations within (and perhaps across) sectors. (1)

In the circumstances just described, where efficiency across sectors requires nominal price changes within a sector or sectors, a zero inflation rate for the consumption price index may no longer be the optimal prescription for monetary policy in the presence of sticky prices. Which inflation rate results in the smallest distortions from price stickiness depends on the details of the environment: chiefly, the rates of relative price change across sectors and the degree of price stickiness in each sector. To cite an extreme example, suppose there are two sectors with different average rates of productivity growth. Suppose further that the sector with low productivity growth (increasing relative price) has sticky prices, whereas the sector with high productivity growth has flexible prices. Then it would be optimal to have deflation overall. Deflation would allow the desired relative price increase to occur with zero nominal price changes for the sticky-price goods and, thus, with no misallocation from the nominal frictions.

The principles for optimal monetary policy I have discussed thus far involve only frictions associated with nominal price adjustment. In reality, monetary policy must balance other frictions as well. As the literature on the Friedman rule emphasizes, the fact that money is nearly costless to produce means that it is socially optimal for individuals to face nearly zero private costs of holding money. This requires a near-zero nominal interest rate, which corresponds to moderate deflation. Other frictions are less well understood, but may be just as important. Many central banks have mandates to achieve price stability, and the fact that my models do not necessarily support this objective does not mean it is misguided; that is, my models may still be lacking. The message of this paper is not that monetary policy should deviate from zero inflation in order to minimize distortions associated with nominal price adjustment. Rather, it is that in the presence of fundamental relative price changes and nominal price adjustment frictions, there is no monetary policy--zero inflation or otherwise--that can render those frictions costless.

Section 1 works through the optimality of price stability in a benchmark one-sector model. Section 2 describes a two-sector model where a trend in relative productivities means that all prices cannot be stabilized. In Section 2 I also display U.S. data for broad categories of consumption, which display trends in relative prices. The data show that even on average, it is not possible to stabilize all nominal prices; trends in relative prices mean that if the price of one category of consumption goods is stabilized then prices for the other categories must have a trend. Furthermore, relative price trends in the United States have been rather large; since 1947, the price of the services component of personal consumption expenditures has risen by a factor of five relative to the price of the durable goods component. Section 3 and 4 provide a brief review of existing literature on relative price variation and monetary policy. In contrast to the material in Section 2, the existing literature has concentrated on random fluctuations in relative prices around a steady state where relative prices are constant. Section 3 reviews the literature on cyclical variation in relative prices, and Section 4 summarizes related work on wages (a form of relative price) and prices across locations. Section 5 concludes.

1. OPTIMALITY OF PRICE STABILITY IN A ONE-SECTOR MODEL

Here I formalize the explanation for how price stability eliminates the distortions associated with price stickiness in a one-sector model. …

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