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Optimal monetary policy with imperfect common knowledge

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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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Bibliographic Info

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
Date of revision:
Handle: RePEc:ecb:ecbwps:20030223

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

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  1. Svensson, Lars E. O. & Woodford, Michael, 2001. "Indicator Variables for Optimal Policy under Asymmetric Information," Seminar Papers 689, Stockholm University, Institute for International Economic Studies.
  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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  14. 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.
  15. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc.
  16. Jeffery Amato & Hyun Song Shin, 2003. "Public and Private Information in Monetary Policy Models," Levine's Bibliography 666156000000000092, UCLA Department of Economics.
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