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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. 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.
  2. George-Marios Angeletos & Alessandro Pavan, 2007. "Policy with Dispersed Information," NBER Working Papers 13590, National Bureau of Economic Research, Inc.
  3. Nimark, Kristoffer, 2008. "Dynamic pricing and imperfect common knowledge," Journal of Monetary Economics, Elsevier, Elsevier, vol. 55(2), pages 365-382, March.
  4. Samuel Wills, 2014. "Optimal Monetary Responses to Oil Discoveries," OxCarre Working Papers, Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford 121, Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford.
  5. Pengfei Wang & Yi Wen, 2007. "Incomplete information and self-fulfilling prophecies," Working Papers, Federal Reserve Bank of St. Louis 2007-033, Federal Reserve Bank of St. Louis.
  6. 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.
  7. Muto, Ichiro, 2013. "Productivity growth, transparency, and monetary policy," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 37(1), pages 329-344.
  8. Manuel Amador & Pierre-Olivier Weill, 2008. "Learning from Prices: Public Communication and Welfare," NBER Working Papers 14255, National Bureau of Economic Research, Inc.
  9. Badarinza, Cristian & Margaritov, Emil, 2011. "News and policy foresight in a macro-finance model of the US," Working Paper Series, European Central Bank 1313, European Central Bank.

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