Optimal Monetary Policy with Durable Consumption Goods and Factor Demand Linkages

Abstract

This paper deals with the implications of factor demand linkages for monetary policy design. We consider a dynamic general equilibrium model with two sectors that produce durable and nondurable goods, respectively. Part of the output of each sector serves as a production input in both sectors, in accordance with a realistic input-output structure. Strategic complementarities induced by factor demand linkages signi…cantly alter the transmission of exogenous shocks and amplify the loss of social welfare under optimal monetary policy, compared to what is observed in standard two-sector models. The distinction between value added and gross output that naturally arises in this context is of key importance to explore the welfare properties of the model economy. Adopting a ‡exible in‡ation targeting regime is close to optimal only if the central bank balances in‡ation and value added variability. Otherwise, targeting gross output variability entails a substantial increase in the loss of welfare.