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Monetary Policy Activism and Price Responsiveness to Aggregate Shocks under Rational Inattention

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Paciello, Luigi

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Abstract

This paper presents a general equilibrium model that is consistent with recent empirical evidence showing that the U.S. price level and inflation are much more responsive to aggregate technology shocks than to monetary policy shocks. The model of this paper builds on recent work by Mackowiak and Wiederholt (2009), who show that models of endogenous attention allocation deliver prices to be more responsive to more volatile shocks as, everything else being equal, firms pay relatively more attention to more volatile shocks. In fact, according to the U.S. data, aggregate technology shocks are more volatile than monetary policy shocks inducing in this paper, firms to pay more attention to the former than to the latter. However, most important, this work adds to the literature by showing that the ability of the model of this paper to account for observed price dynamics crucially depends on monetary policy. In particular, this paper shows how interest rate feedback rules affect the incentives faced by firms in allocating attention. A policy rate responding more actively to expected inflation and output fluctuations induces firms to pay relatively more attention to more volatile shocks. This new mechanism of transmission of monetary policy helps rationalizing the observed behavior of prices in response to technology and monetary policy shocks, and implies novel predictions about the impact of changes in Taylor rules coefficients on economic fluctuations.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 16407.

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Date of creation: 18 Jul 2009
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Handle: RePEc:pra:mprapa:16407

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Related research
Keywords: Rational inattention; monetary policy; technology shocks; prices;

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Find related papers by JEL classification:
E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles

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  2. Blanchard, Olivier Jean & Kiyotaki, Nobuhiro, 1987. "Monopolistic Competition and the Effects of Aggregate Demand," American Economic Review, American Economic Association, vol. 77(4), pages 647-66, September. [Downloadable!] (restricted)
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  4. Frank Smets & Rafael Wouters, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic Review, American Economic Association, vol. 97(3), pages 586-606, June. [Downloadable!]
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  5. Athanasios Orphanides, 2003. "Historical monetary policy analysis and the Taylor rule," Finance and Economics Discussion Series 2003-36, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  6. George-Marios Angeletos & Alessandro Pavan, 2008. "Policy with Dispersed Information," Carlo Alberto Notebooks 86, Collegio Carlo Alberto. [Downloadable!]
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  7. N. Gregory Mankiw & Ricardo Reis, 2006. "Pervasive Stickiness," Harvard Institute of Economic Research Working Papers 2111, Harvard - Institute of Economic Research. [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. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April. [Downloadable!] (restricted)
  10. Bartosz Maćkowiak & Mirko Wiederholt, 2009. "Optimal sticky prices under rational inattention," Working Paper Series 1009, European Central Bank. [Downloadable!]
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  11. Altig, David E & Christiano, Lawrence J. & Eichenbaum, Martin & Lindé, Jesper, 2005. "Firm-Specific Capital, Nominal Rigidities and the Business Cycle," CEPR Discussion Papers 4858, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  12. Christian Hellwig & Laura Veldkamp, 2009. "Knowing What Others Know: Coordination Motives in Information Acquisition," Review of Economic Studies, Blackwell Publishing, vol. 76(1), pages 223-251, 01. [Downloadable!] (restricted)
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