The Optimal Rate of Inflation 687

remaining (1 — a) firms choose prices optimally. Suppose firm i gets to pick its
price in period t, and let Peit denote the chosen price. This price is set to
maximize the
expected present discounted value of profits. That is, Peit maximizes

E Xrt;s . t Σ1—yas — rs kis —

i
þ mcs zsFðkis; h is Þ — i
t a :
t s¼ 1
as—t .Σ Pe
P wshis k Σ— Σ P s
t w . P Σ—y ΣΣ
e
The first-order condition associated with this maximization problem is
E X1 . Σ—1 y—1
s
Pe asΣmcs Σ ¼ 0:
t r—tt;sa —y Peit
i —
t
s¼t y Ps

Ps

According to this expression, firms whose price is free to adjust in the current period
pick a price level such that a weighted average of current and future expected differ-
ences between marginal costs and marginal revenue equals zero. Moreover, it is clear
from this optimality condition that the chosen price Peit is the same for all firms that
can reoptimize their price in period t. We can therefore drop the subscript i from
eit . We link the aggregate price level Pt to the price level chosen by the (1 — a)
P
firms that reoptimize their price in period
e t, P t. To this end, we write the definition of
the aggregate price level given in Eq. (42) as follows 1—
P1—y ¼ aP1—y yþ: ð1 — aÞP
e
t t—1 t

Letting pet ÷ Pt denote the relative price of goods produced by firms that reoptimize
P
t

e in period t and pt ÷ Pt/Pt—1 denote the gross rate of inflation in period t,

their price
the previous expression can be written as
1 ¼ apy—1
t þ ð1 — aÞep
t
1—y
:
We derive an aggregate resource constraint for the economy by imposing market
clearing at the level of intermediate goods. Specifically, the market clearing
condition in the market for intermediate good i is given by
ztFðkit; h it Þ— w ¼ ait:
Taking into account that a ¼ a .Pi Σ—y , and the capital labor ratio k /h is independent
it t Pt it it
of i, and that the function F is homogeneous of degree of one, we can integrate the
preceding market clearing condition over all goods i to obtain
kt
ht zt F. ; 1Σ — w ¼ s ta t;
h
Ð1 Ð1
where ht ÷ hitdi and kt ÷ kitdi denote
t
the aggregate levels of labor and capital
 Ð . Σ—y
0 0
1 Pi
services in period t and st 0 t di is a measure of price dispersion. To
÷ P complete
the aggregation of the model we express
t
the variable st recursively as
follows