THE PAKISTAN DEVELOPMENT REVIEW
Nominal Frictions and Optimal Monetary Policy
It is well known in standard economic literature that nominal frictions have significant impact on the transmission mechanism of monetary policy. This paper considers a closed economy version of DSGE model with various nominal frictions vis-à-vis monetary-cumfiscal blocks to seek the basic query that how monetary policy impacts while in the presence of nominal frictions, like price stickiness, staggered wages, etc. Using Bayesian Simulation techniques, we estimate the model for the closed economy. Our simulation results show that despite the apparent similarities of various frictions, their responses to shocks and fit to data are quite different and there is no agreement on their relative performance. As a result, Monetary Authorities cannot afford to rely on a single reference model which contains few nominal frictions of the economy but need to model a large number of alternative ways available when they take their decision of optimal monetary policy.