Optimal Monetary Policy Under Menu Costs

We analytically characterize optimal monetary policy in a multisector economy with menu costs and contrast it with the textbook New Keynesian model based on Calvo pricing. Following a sectoral productivity shock, the textbook model prescribes zero inflation, providing a formal justification for inflation targeting. In contrast, under menu costs, policy should “look through” sectoral shocks and allow inflation to move inversely with output. We provide sharp intuition for this result: stabilizing inflation causes shocks to spill over across sectors, forcing firms to adjust unnecessarily. Finally, in a quantitative model, moving from inflation targeting towards optimal policy improves welfare by 0.32%.