Abstract
Recent literature on the design of optimal monetary policy has shown that deviations from price stability are small whenever prices are sticky. This paper reconsiders this issue by introducing capital accumulation in the model. Optimal monetary policy in this setup implies small deviations from price stability. The monetary authority optimally uses inflation as an explicit tax on monopolistic profits to reduce the price markup across states. Variable markup is achieved in this setup because the share of investment demand over output varies across states and in response to TFP shocks.
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