Ramsey Monetary Policy with Capital Accumulation and Nominal Rigidities”. Forthcoming in Macroeconomic Dynamics

Recent literature on the design of optimal monetary policy has shown that devia-tions 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 set-up implies small deviations from price stability. The monetary authority optimally uses inflation as an explicit tax on monopolistic profits to reduce the price mark-up across states. Variable mark-up is achieved in this set-up since the share of investment demand over output varies across states and in response to TFP shocks