Optimal Monetary Policy with Government-Provided Unemployment Benefits

Abstract This paper considers a standard New Keynesian model with matching frictions and explores the impact of modeling the opportunity cost of employment as government unemployment transfers. The findings reveal that under such circumstances, maintaining full price stability at all times ceases to be optimal. This outcome persists even when production subsidies are introduced to address inefficiencies caused by imperfect competition in product and factor markets, and when wages are fully flexible and the Hosios condition holds. For a realistic calibration of the opportunity cost, the Ramsey-optimal policy necessitates a positive inflation rate with high volatility. The degree of inflation volatility required increases with the magnitude of unemployment transfers. Consequently, committing to an inflation targeting regime proves to be highly costly in this context. Additionally, the study demonstrates that the optimal inflation variability decreases with workers’ bargaining power. This is because higher workers’ bargaining power leads to reduced labor market fluctuations, thereby lowering the need for large inflation adjustments.