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Traditional New Keynesian models prescribe that optimal monetary policy should aim at price stability. In the absence of a labor market frictions, the monetary authority faces no unemployment/inflation trade-off. The design of optimal monetary policy is analyzed here for a framework with sticky prices and matching frictions in the labor market. Optimal policy features deviations from price stability in response to both productivity and government expenditure shocks. When the Hosios [1990. On the efficiency of matching and related models of search and unemployment. Review of Economic Studies 57 (2), 279–298] condition is not met, search externalities make the flexible price allocation unfeasible. Optimal deviations from price stability increase with workers’ bargaining power, as firms incentives to post vacancies fall and unemployment fluctuates above the Pareto efficient one.

Most of the recent literature on optimal monetary policy design using New Keynesian models neglects labor market frictions, which are the main cause of the existence of a short-run unemployment/inflation trade-off. Absent this, optimal monetary policy invariably consists in implementing the flexible price allocation through a zero inflation policy. This paper instead analyzes optimal monetary policy in a model economy characterized by price adjustment costs a’ la Rotemberg (1982) and matching frictions in the labor market a’ la Mortensen and Pissarides (1999). Several recent papers have studied the quantitative implications of introducing matching frictions in a standard New Keynesian framework,1 but very little has been done on the normative side. Our economy has three sources of inefficiency, both in the long and in the short run. The first is monopolistic competition, which induces an inefficiently low level of output thereby calling for mild deviations from strict price stability. The second type of distortion stems from the cost of adjusting prices, which reduces output below the efficient level thereby calling for closing the “inflation gap”. The third stems from a congestion externality that tightens the labor market and induces inefficient unemployment fluctuations. In this context the policy maker faces a trade-off between stabilizing inflation and reducing inefficient unemployment fluctuations and an incentive to deviate from full price stabilization.

This paper derives optimal monetary policy in a model with monopolistic competition, sticky prices and matching frictions. In response to both productivity and government expenditure shocks, the optimal policy deviates from price stability. This is because search externalities generate an unemployment/inflation trade-off, and the monetary authority has to strike a balance between reducing the cost of adjusting prices and increasing an inefficiently low employment. In response to both shocks the optimal inflation volatility increases with the workers’ bargaining power. As the latter increases, the share of surplus allocated to workers increases and firms have little incentives to post vacancies. Under those circumstances the unemployment rate rises above the Pareto efficient one and the monetary authority faces a steeper trade-off between stabilizing inflation and reducing inefficient unemployment fluctuations