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 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 price setting restrictions, but not the distortion due to monopolistic competition. 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, so that a simple criterion of eliminating gaps is not optimal. Sticky prices provide the planner with tools to improve upon a distorted flexible price allocation.1. As is common in this literature, gaps refer to the deviations of the sticky price allocation from the flexible price one, for a given policy. 699 700 REVIEW OF ECONOMIC STUDIESSticky prices provide the planner with policy tools to improve upon a distorted flexible price allocation. Under flexible prices, only the interest rate matters. The optimal monetary policy is to set the nominal interest rate to zero, so that the wedge between the marginal rate of substitution and the marginal rate of transformation is minimized in each date and state. The optimal allocation will be distorted by a constant mark-up.Under sticky prices, it is still optimal to set the nominal interest rate to zero, and under particular conditions on preferences, technology, and the nature of shocks, the flexible price constant mark-ups are optimal. However, in general, the optimal allocation under sticky prices will be characterized by variable mark-ups. These variable proportionate wedges cannot be attained under flexible prices because the nominal interest rate cannot be negative. Under sticky prices, the planner is able to use money supply policy to side-step the zero bound restriction on the nominal interest rate and achieve higher utility.The literature on optimal monetary policy in imperfectly competitive and sticky price economies is relatively recent. Papers related to the current analysis include Ireland . These papers analyse environments with a basic structure similar to ours, but with three main differences. They allow for fiscal instruments that undo the monopolistic competition distortion; the economies are cashless; and prices are set in a staggered fashion. The nominal rigidities are the only relevant distortions so that the flexible price allocation, if feasible, is optimal.King and Wolman (1999) study a staggered price setting model in which the monopolistic competition distortion is operative, but remove the nominal interest rate distortion by allowing for interest to be paid on currency. They show that the flexible price solution is optimal in the deterministic case. Kahn et al. (2000) retain the money demand distortion and solve the optimal policy problem numerically. They show that the optimal alloc...

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We study environments with sticky prices, wages, or portfolios where it is feasible and optimal to use monetary policy to replicate the allocation under full flexibility. In these environments the optimal policy does not depend on the scope of the frictions. In this sense, the strength of the monetary transmission mechanism is irrelevant for the conduct of monetary policy. So, asymmetries in the strength of the transmission mechanisms do not impose a cost on a common policy. (JEL: E31, E41, E58, E62)