Price in Utility and Optimal Monetary Policy
with Fabio Ghironi
Abstract
We introduce price level into household utility function to study the optimal monetary policy. In our framework, price level above the household’s neutral level generates "bad feeling" for households, thus dampens their utilities. Under flexible prices, the conventional Friedman rule is not sufficient to guarantee efficient allocation under the benevolent social planner. The optimal monetary policy must also address any deviations of the price level from the household’s neutral level. In a sticky-price environment, including price level in the utility function produces a steeper New Keynesian Phillips Curve and a flatter Dynamic IS curve, indicating that the central bank needs to act more aggressively on inflation but less aggressively on the output gap compared to what has been suggested by the standard model.
Draft available upon request