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Optimal monetary policy with imperfect common knowledge

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Author Info
Klaus Adam () (European Central Bank, Postfach 160319, 60311 Frankfurt am Main, Germany.)

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Abstract

We study optimal nominal demand policy in an economy with monopolistic competition and flexible prices when firms have imperfect common knowledge about the shocks hitting the economy. Information imperfections emerge endogenously because firms are assumed to have finite (Shannon) capacity to process information. We then ask how policy that minimizes a quadratic objective in output and prices depends on firms' processing capacity. When price setting decisions are strategic complements, for a large range of capacity values optimal policy nominally accommodates mark-up shocks in the short-run. This holds even if the policy maker observes shocks imperfectly or is uncertain about firms' capacity parameter. With persistent mark-up shocks accommodation may increase in the medium term, but decreases in the long-run thereby generating a hump-shaped price response and a slow reduction in output. JEL Classification: E31; E52; D82.

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Paper provided by European Central Bank in its series Working Paper Series with number 223.

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Length: 38 pages
Date of creation: Apr 2003
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Handle: RePEc:ecb:ecbwps:20030223

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Related research
Keywords: Optimal policy; information frictions; imperfect common knowledge; higher order beliefs; Shannon capacity.;

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References listed on IDEAS
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  1. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Atsushi Kajii & Stephen Morris, 1997. "The Robustness of Equilibria to Incomplete Information," Econometrica, Econometric Society, vol. 65(6), pages 1283-1310, November.
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  3. Jeffery Amato & Hyun Song Shin, 2003. "Public and Private Information in Monetary Policy Models," Levine's Bibliography 666156000000000092, UCLA Department of Economics. [Downloadable!]
  4. Stephen Morris & Hyun S Shin, 2001. "Global Games: Theory and Applications," Levine's Working Paper Archive 122247000000001080, David K. Levine. [Downloadable!]
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  5. Bacchetta, Philippe & van Wincoop, Eric, 2003. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," CEPR Discussion Papers 3808, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  6. Hyun Song Shin & Jeffery D. Amato, 2003. "Public and private information in monetary policy models," BIS Working Papers 138, Bank for International Settlements. [Downloadable!]
  7. Laurence Ball & N Gregory Mankiw & Ricardo Reis, 2003. "Monetary Policy for Inattentive Economies," Economics Working Paper Archive 491, The Johns Hopkins University,Department of Economics. [Downloadable!]
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  8. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April. [Downloadable!] (restricted)
  9. Sargent, Thomas J., 1991. "Equilibrium with signal extraction from endogenous variables," Journal of Economic Dynamics and Control, Elsevier, vol. 15(2), pages 245-273, April. [Downloadable!] (restricted)
  10. Svensson, Lars E. O. & Woodford, Michael, 2004. "Indicator variables for optimal policy under asymmetric information," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 661-690, January. [Downloadable!] (restricted)
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  11. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April. [Downloadable!] (restricted)
  12. Kenneth Kasa, 2000. "Forecasting the Forecasts of Others in the Frequency Domain," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(4), pages 726-756, October. [Downloadable!] (restricted)
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  13. Christian Hellwig, 2002. "Public Announcements, Adjustment Delays, and the Business Cycle (November 2002)," UCLA Economics Online Papers 208, UCLA Department of Economics. [Downloadable!]
  14. Binder, Michael & Pesaran, M Hashem, 1998. "Decision Making in the Presence of Heterogeneous Information and Social Interactions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 1027-52, November.
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  15. Hyun Song Shin & Jeffery D. Amato, 2003. "Public and Private Information in Monetary Policy Models," Computing in Economics and Finance 2003 38, Society for Computational Economics. [Downloadable!]
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