Recent literature on the design of optimal monetary policy has shown that deviations
from price stability are small whenever prices are sticky. This paper reconsiders
this issue by introducing capital accumulation in the model. Optimal monetary policy
in this set-up implies small deviations from price stability. The monetary authority
optimally uses inflation as an explicit tax on monopolistic profits to reduce the price
mark-up across states. Variable mark-up is achieved in this set-up since the share of
investment demand over output varies across states and in response to TFP shocks.