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Demand Shocks and Monetary Policy

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  • Guido Lorenzoni

    ()
    (Department of Economics, MIT)

Abstract

This paper studies the effects of monetary policy in a model with demand shocks driven by shifts in consumer expectations. I ask wether monetary policy can offset these aggregate demand disturbances and wether this offsetting is socially desirable. I consider an environment with dispersed information and two aggregate shocks: a fundamental shock which affects potential output (a productivity shock), and a demand shock which affects aggregate spending but not potential output (a shock to public beliefs). Neither the central bank nor any individual agent can distinguish the two shocks, when they hit the economy. In this environment I show three results: (1) despite the lack of superior information, an appropriate policy rule can change the economy responses to the two shocks; (2) an appropriate policy rule can achieve full aggregate stabilization, i.e. zero output gap; (3) full stabilization is not desirable, that is, there is an optimal degree of accommodation of aggregate demand shocks.

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Bibliographic Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 524.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:524

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Related research

Keywords: Optimal monetary policy; consumer sentiment; imperfect information;

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Cited by:
  1. Guido Lorenzoni, 2009. "A Theory of Demand Shocks," American Economic Review, American Economic Association, vol. 99(5), pages 2050-84, December.
  2. Antonella Tutino, 2008. "The rigidity of choice: Lifecycle savings with information-processing limits," Finance and Economics Discussion Series 2008-62, Board of Governors of the Federal Reserve System (U.S.).

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