Uncertainty shocks, precautionary pricing, and optimal monetary policy

Existing studies show that, in standard New Keynesian models, uncertainty shocks manifest as cost-push shocks due to the precautionary pricing channel. We study optimal monetary policy in response to uncertainty shocks when the precautionary pricing channel is operative. We show that, in the absence of real imperfections, the optimal monetary policy fully stabilizes the output gap and inflation, implying no policy trade-offs. Our result suggests that precautionary pricing matters only insofar as expected inflation is volatile. Thus, a simple Taylor rule that places high weight on inflation leads to a stabilized output gap, thereby attaining the “divine coincidence”.