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Abstract

I construct a New Keynesian DSGE model featuring household consumption of intermediate goods and double marginalization. Without double marginalization, the central bank should target sticky-price inflation only, even if sticky-price goods are made from flexible-price consumption goods. With double marginalization, the first- best allocation is no longer attainable. To analyze the welfare implications of these two features, I report the expected period welfare losses of the Taylor rule and the optimal monetary policy in Huang and Liu (2005). When there is household consumption of intermediate goods, ignoring double marginalization leads to an underestimation of the welfare losses of the Taylor Rule by nearly one third, or 0.38% of the steady state consumption level. When there is double marginalization, considering household consumption of intermediate goods and re-optimizing weights on inflation rates in different sectors will improve the performance of the optimal monetary policy in Huang and Liu (2005) by about 6.5%, or 0.0025% of the steady state consumption level.

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