We formulate an optimizing-agent model in which both labor and product markets exhibit monopolistic competition and staggered nominal contracts. The unconditional expectation of average household utility can be expressed in terms of the unconditional variances of the output gap, price inflation, and wage inflation. Monetary policy cannot replicate the Pareto-optimal equilibrium that would occur under completely flexible wages and prices; that is, the model exhibits a tradeoff between stabilizing the output gap, price inflation, and wage inflation. The Pareto optimum is only attainable if either wages or prices are completely flexible. For reasonable calibrations of the model, we characterize the optimal policy rule. Furthermore, strict price inflation targeting is clearly suboptimal, whereas rules that place substantial weight on the output gap as well as price inflation are nearly optimal.

We formulate an optimizing-agent model in which both labor and product markets exhibit monopolistic competition and staggered nominal contracts. The unconditional expectation of average household utility can be expressed in terms of the unconditional variances of the output gap, price inflation, and wage inflation. Monetary policy cannot replicate the Pareto-optimal equilibrium that would occur under completely flexible wages and prices; that is, the model exhibits a tradeoff between stabilizing the output gap, price inflation, and wage inflation. The Pareto optimum is only attainable if either wages or prices are completely flexible. For reasonable calibrations of the model, we characterize the optimal policy rule. Furthermore, strict price inflation targeting is clearly suboptimal, whereas rules that place substantial weight on the output gap as well as price inflation are nearly optimal.

In this paper, we formulate a dynamic general equilibrium model with staggered nominal contracts, in which households and Þrms use optimal Þltering to disentangle persistent and transitory shifts in the monetary policy rule. The calibrated model accounts quite well for the dynamics of output and inßation during the Volcker disinßation, and implies a sacriÞce ratio very close to the estimated value. Our approach indicates that inßation persistence and substantial costs of disinßation can be generated in an optimizing-agent framework, without relaxing the assumption of rational expectations or relying on arbitrary modiÞcations to the aggregate supply relation.