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Money Demand by Firms, Labor Market Frictions, and Optimal Long-Run Inflation

This article analytically and quantitatively studies optimal monetary policy, under flexible- and sticky- prices, and sticky nominal wages in canonical matching model of the labor market with a working capital channel. A money demand by firms is motivated by the facts that in advanced economies about 2/3 of M1 is held by firms, and that since the 2008 financial crisis the U.S. nonfinancial corporations holdings of currency have hugely increased. The main result of the article is to show that, due to the presence of the working capital channel, the Ramsey-optimal monetary policy calls for inflation when employment is above the socially efficient level, and for deflation when it is below the efficient level. The main mechanism holds under flexible wages as well as nominal wage rigidities. In other words, to improve labor market efficiency, deflation is necessary to “grease the wheels of the labor market.” This stands in sharp contrast to the existing results that call for inflation when unemployment is inefficiently high. We show that although there is no relationship between optimal monetary policy and the market tightness under flexible prices, a long-run and mainly negative relationship between the optimal inflation rate and the equilibrium tightness emerges under sticky prices.