Seminar in Macroeconomics - Gernot Müller (University of Tuebingen)

The defining feature of the New Keynesian model is that goods prices are adjusted infrequently. In the one-sector version of the model, goods are intrinsically homogeneous and should trade at the same price. By targeting inflation, monetary policy can achieve the efficient allocation. In the network version of the model, sectoral shocks call for an adjustment of relative prices and give rise to a trade-off between adjusting relative prices across sectors and maintaining price stability within sectors. Monetary policy alone can no longer achieve the first best. Against this background, we study the optimal tax response to sectoral shocks. It features twice as many tax instruments as there are sectors, is budget-neutral, and is not confined to the sector where the shock originates. A simple rule that targets sectoral inflation approximates the optimal policy well. We illustrate the quantitative relevance of our results using a calibrated version of the model.