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Nominal Rigidities, Monetary Policy and Pigou Cycles

  • Stephane Auray

    ()

    (EQUIPPE (EA 4018), Universit�s Lille Nord de France (ULCO), GREDI, Universit� de Sherbrooke and CIRP\Eacute;E.)

  • Paul Gomme

    ()

    (Concordia University and CIREQ)

  • Shen Guo

    ()

    (China Academy of Public Finance and Public Policy, Central University of Finance and Economics, Beijing, China)

Based on a two sector dynamic new Keynesian model with sticky prices, this paper makes two contributions to the Pigou cycle literature. First, the paper quantifies the contribution of `news shocks' -- signals of future productivity changes. Maximum likelihood estimates indicate that nondurable sector news shocks are roughly as volatile as contemporary shocks; in the durable good sector, the standard deviation of news shocks is 1/4 that of contemporaneous shocks. Second, and perhaps more importantly, the paper shows that the estimated interest rule contributes to Pigou cycles arising from nondurable sector news shocks. In particular, the Ramsey-optimal policy does not exhibit Pigou cycles while the estimated policy rule does. With sticky prices, intermediate good producers set current prices based on expected future marginal cost. The news shock implies a lower future marginal cost, and so nondurable goods prices start falling immediately. The estimated interest rate rule then prescribes a lower nominal interest rate, and so a fall in both the real interest rate and user cost of durables. As a result, purchases of durables also rise. In contrast, the Ramsey-optimal policy requires a higher nominal interest rate because the Ramsey policy attempts to minimize the distortions associated with within-sector price dispersion. The resulting dynamics under the Ramsey policy are, then, essentially the opposite of those under the estimated policy. Put simply, Pigou cycles arise in the model precisely because the central bank accommodates them.

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File URL: http://paulgomme.github.io/Pigou.pdf
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Paper provided by Concordia University, Department of Economics in its series Working Papers with number 09005.

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Length: 35 pages
Date of creation: 02 Jul 2009
Date of revision: 06 Apr 2010
Handle: RePEc:crd:wpaper:09005
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