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News Shocks and Optimal Monetary Policy

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  • Guido Lorenzoni

Abstract

This paper studies monetary policy in a model where output fluctuations are caused by shocks to public beliefs on the economy's fundamentals. I ask whether monetary policy can offset the effect of these shocks and whether this offsetting is socially desirable. I consider an environment with dispersed information and two aggregate shocks: a productivity shock and a "news shock" which affects aggregate beliefs. Neither the central bank nor individual agents can distinguish the two shocks when they hit the economy. The main results are: (1) despite the lack of superior information an appropriate monetary policy rule can change the economy's response to the two shocks; (2) monetary policy can achieve full aggregate stabilization, that is, it can induce a path for aggregate output that is identical to that which would arise under full information; (3) however, full aggregate stabilization is typically not optimal. The fact that monetary policy can tackle the two shocks separately is due to two crucial ingredients. First, agents are forward looking. Second, current fundamental shocks will become public information in the future and the central bank will be able to respond to them at that time. By announcing its response to future information, the central bank can influence the expected real interest rate faced by agents with different beliefs and, thus, induce an optimal use of the information dispersed in the economy.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12898.

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Date of creation: Feb 2007
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Handle: RePEc:nbr:nberwo:12898

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Citations

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Cited by:
  1. Pengfei Wang & Yi Wen, 2007. "Incomplete information and self-fulfilling prophecies," Working Papers 2007-033, Federal Reserve Bank of St. Louis.
  2. Ichiro Muto, 2007. "Productivity Growth, Transparency, and Monetary Policy," IMES Discussion Paper Series 07-E-08, Institute for Monetary and Economic Studies, Bank of Japan.
  3. Kristoffer Nimark, 2007. "Dynamic Pricing and Imperfect Common Knowledge," RBA Research Discussion Papers rdp2007-12, Reserve Bank of Australia.
  4. George-Marios Angeletos & Guido Lorenzoni & Alessandro Pavan, 2007. "Wall Street and Silicon Valley: A Delicate Interaction," NBER Working Papers 13475, National Bureau of Economic Research, Inc.
  5. George-Marios Angeletos & Alessandro Pavan, 2008. "Policy with Dispersed Information," Carlo Alberto Notebooks 86, Collegio Carlo Alberto.
  6. Badarinza, Cristian & Margaritov, Emil, 2011. "News and policy foresight in a macro-finance model of the US," Working Paper Series 1313, European Central Bank.
  7. Samuel Wills, 2013. "Optimal Monetary Responses to Oil Discoveries," Economics Series Working Papers OxCarre Research Paper 12, University of Oxford, Department of Economics.
  8. Manuel Amador & Pierre-Olivier Weill, 2010. "Learning from Prices: Public Communication and Welfare," Journal of Political Economy, University of Chicago Press, vol. 118(5), pages 866 - 907.
  9. Tille, Cédric & van Wincoop, Eric, 2008. "International Capital Flows under Dispersed Information: Theory and Evidence," CEPR Discussion Papers 6989, C.E.P.R. Discussion Papers.

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