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Optimal Monetary Policy with Imperfect Common Knowledge

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  • Adam, Klaus

Abstract

This Paper studies optimal nominal demand policy in a flexible price economy with monopolistic competition and inattentive firms (Shannon). Inattentiveness gives rise to idiosyncratic information errors and imperfect common knowledge about the shocks hitting the economy. Strategic complementarities in the price-setting game between firms then strongly amplify the effects of information frictions and the real effects of monetary policy. Therefore, strategic complementarities make it optimal to stabilize the output gap by nominally accommodating shocks to firms’ desired mark-up. As mark-up shocks become more persistent, however, optimal policy is again increasingly characterized by price level stabilization. Shocks to the natural rate of output are found not to generate a policy trade-off.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4594.

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Date of creation: Sep 2004
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Handle: RePEc:cpr:ceprdp:4594

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Keywords: information imperfections; nominal demand management; Private information; rational inattention; Shannon capacity;

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References

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  1. Hyun Song Shin & Jeffery D. Amato, 2004. "Public and Private Information in Monetary Policy Models," Econometric Society 2004 North American Winter Meetings 59, Econometric Society.
  2. Stephen Morris & Hyun Song Shin, 2000. "Global Games: Theory and Applications," Cowles Foundation Discussion Papers 1275R, Cowles Foundation for Research in Economics, Yale University, revised Aug 2001.
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  17. Nimark, Kristoffer P., 2005. "Calvo pricing and imperfect common knowledge: a forward looking model of rational inflation inertia," Working Paper Series 0474, European Central Bank.
  18. Jeffery Amato & Hyun Shin, 2006. "Imperfect common knowledge and the information value of prices," Economic Theory, Springer, vol. 27(1), pages 213-241, 01.
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