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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. Samuel Wills, 2014. "Optimal Monetary Responses to Oil Discoveries," CAMA Working Papers 2014-37, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  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. Manuel Amador & Pierre Olivier Weill, 2008. "Learning from Prices: Public Communication and Welfare," 2008 Meeting Papers 390, Society for Economic Dynamics.
  4. Badarinza, Cristian & Margaritov, Emil, 2011. "News and policy foresight in a macro-finance model of the US," Working Paper Series 1313, European Central Bank.
  5. Kristoffer Nimark, 2007. "Dynamic Pricing and Imperfect Common Knowledge," RBA Research Discussion Papers rdp2007-12, Reserve Bank of Australia.
  6. Cédric Tille & Eric van Wincoop, 2008. "International Capital Flows under Dispersed Information: Theory and Evidence," NBER Working Papers 14390, National Bureau of Economic Research, Inc.
  7. Pengfei Wang & Yi Wen, 2007. "Incomplete information and self-fulfilling prophecies," Working Papers 2007-033, Federal Reserve Bank of St. Louis.
  8. Alessandro Pavan & George-Marios Angeletos, 2008. "Policy with Dispersed Information," 2008 Meeting Papers 1103, Society for Economic Dynamics.
  9. 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.

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