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Nominal Rigidities, Monetary Policy and Pigou Cycles

  • Stephane Auray

    ()

    (CREST-Ensai, Universite du Littoral Cote d'Opale (EQUIPPE),GREDI and CIRPEE)

  • Paul Gomme

    ()

    (Concordia University and CIREQ)

  • Shen Guo

    ()

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

This paper makes two contributions to the literature. First, it explores the role of monetary policy in generating Pigou cycles. Second, the paper provides a partial resolution of the comovement problem associated with monetary policy shocks. The paper estimates a two sector dynamic new Keynesian model with sticky prices. The estimated interest rate rule allows for Pigou cycles -- an immediate boom in economic activity upon receipt of perfectly informative news of a future productivity improvement. For Pigou cycles to occur, there has to be sufficient movement in durable and nondurable sector inflation rates to lead to a sharp increase in the relative price of durables following a nondurable sector news shock. An interest rate rule with a larger coefficient on inflation keeps sectoral inflation rates closer to their steady state values, leading to a more moderate increase in the relative price of durables. The Ramsey-optimal policy likewise dampens the movements in sectoral inflation rates and avoids Pigou cycles. Thus, Pigou cycles emerge in the estimated model for the simple reason that the central bank accommodates them. The paper also provides a partial resolution of the comovement problem: the impact effect of a monetary policy shock leads to positive comovement between the durables and nondurable sectors, as seen in the data. The paper shows that the comovement problem arises when durable sector prices are less rigid than estimated, and the elasticity of substitution between durables and nondurables is higher than estimated.

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File URL: http://paulgomme.github.io/Pigou2011.pdf
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Paper provided by Concordia University, Department of Economics in its series Working Papers with number 11007.

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Length: 60 pages
Date of creation: Nov 2011
Date of revision: Nov 2011
Handle: RePEc:crd:wpaper:11007
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