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Phillips Curve Instability and Optimal Monetary Policy By Troy Davig |
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Abstract This paper assesses the implications for optimal
discretionary monetary policy if the slope of the Phillips curve changes.
The paper first derives a ‘switching’ Phillips curve from the optimal
pricing decision of a monopolistic firm that faces a changing cost of price
adjustment. Two states exists, a state with a high cost of price adjustment
that generates a ‘flat’ Phillips curve and a low-cost state that generates a
relatively ‘steep’ curve. The second aspect of the paper constructs a
utility-based welfare criterion. A novel feature of this criterion is that
it has a relative weight on output gap deviations that is state dependent,
so it changes with the cost of price adjustment. Optimal monetary policy is
computed subject to the switching-Phillips curve under both ad-hoc and
utility-based welfare criteria. The utility-based criterion instructs
monetary policy to disregard the slope of the Phillips curve and keep its
systematic actions constant across different states. This stands in contrast
to the prescription coming under the ad-hoc criterion, which advises
monetary policy to change its systematic behavior according to the slope of
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