Optimal Monetary Policy Under Sectoral Interconnections

We explore the role of intersectoral factor demand linkages for the design of optimal monetary policy. A two-sector new-Keynesian model is developed in which the sectors are connected through factor demand linkages. Moreover, they differ in price stickiness. We obtain two important results: first, the presence of factor demand linkages causes amplification effects in resource mis-allocation and, hence, the concern for price stability becomes relatively more important. Second, the optimal price index is not the same as the aggregate price index, although it does not directly depend on the factor demand linkages themselves. Furthermore, based on the micro-founded loss function we derive a policy rule that implements the optimal allocation.