A Linear Quadratic Approach to Optimal Monetary Policy with Unemployment and Sticky Prices: The Case of a Distorted Steady State

Abstract

Ravenna and Walsh (2010) develop a linear quadratic framework for optimal monetary policy analysis in a New Keynesian model featuring search and matching frictions and show that maximization of expected utility of the representative household is equivalent to minimizing a quadratic loss function that consists of in‡ation, and two appropriately de…ned gaps involving unemployment and labor market tightness. This paper generalizes their analysis, most importantly by relaxing the Hosios (1990) condition which eliminates the distortions resulting from labor market ine¢ ciencies, such that the equilibrium level of unemployment under ‡exible prices would not necessarily be optimal. I take account of steady-state distortions using the methodology of Benigno and Woodford (2005) and derive a quadratic loss function that involves the same three