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Money demand by firms, labor market frictions, and optimal long-run inflation

Published online by Cambridge University Press:  14 February 2023

Mehrab Kiarsi
Mehrab Kiarsi*
Affiliation:
School of Economics, Henan University, Kaifeng, China
*
Email: mkiarsi@gmail.com
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Abstract

Optimal monetary policy, under flexible and sticky prices, and sticky nominal wages are studied in the canonical matching model of the labor market with a working capital channel. A money demand by firms is motivated by the fact that a significant amount of M1 is held by firms. As a result of the working capital, the Ramsey-optimal monetary policy calls for inflation when employment is above the socially efficient level and for deflation when it is below that level. This result holds under flexible wages as well as nominal wage rigidities. In other words, to improve labor market efficiency, deflation is necessary to “grease the wheels of the labor market.” Although there is no relationship between optimal monetary policy and the market tightness under flexible prices, a long-run and mainly negative relationship between the optimal inflation rate and the equilibrium tightness emerges under sticky prices.

Keywords

Optimal monetary policyfrictional labor marketsworking capital channel
Type
Articles
Information
Macroeconomic Dynamics , Volume 28 , Issue 1 , January 2024 , pp. 204 - 233
Copyright
© The Author(s), 2023. Published by Cambridge University Press

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Footnotes

*

I am grateful to the Associate Editor and two anonymous referees for their helpful comments. I am also grateful to Mohammad Davoodalhosseini for his valuable time and important feedback on this paper. I have also benefited from conversations with Stephanie Schmitt-Grohe and Martin Uribe during my stay at the Department of Economics of Columbia University as a research scholar.

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