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Optimal monetary policy with imperfect common knowledge

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  • Backé, Peter

Abstract

We study optimal nominal demand policy in an economy with monopolistic competition and flexible prices when firms have imperfect common knowledge about the shocks hitting the economy. Parametrizing firms' information imperfections by a (Shannon) capacity parameter that constrains the amount of information flowing to each firm, we study how policy that minimizes a quadratic objective in output and prices depends on this parameter. When price setting decisions of firms are strategic complements, for a large range of capacity values optimal policy nominally accommodates mark-up shocks in the short-run. This finding is robust to the policy maker observing shocks imperfectly or being uncertain about firms' capacity parameter. With persistent mark-up shocks accommodation may increase in the medium term, but decreases in the long-run thereby generating a hump-shaped price response and a slow reduction in output. Instead, when prices are strategic substitutes, policy tends to react restrictively to mark-up shocks. However, rational expectations equilibria may then not exist with small amounts of imperfect common knowledge. JEL Classification: E31, E52, D82

Suggested Citation

  • Backé, Peter, 2003. "Optimal monetary policy with imperfect common knowledge," Working Paper Series 223, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2003223
    Note: 508510
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    File URL: https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp223.pdf
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    References listed on IDEAS

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    Cited by:

    1. Jeffery Amato & Hyun Song Shin, 2003. "Public and Private Information in Monetary Policy Models," Levine's Bibliography 666156000000000092, UCLA Department of Economics.
    2. Péter Kondor, 2009. "The more we know, the less we agree: Higher-order expectations and public announcements," 2009 Meeting Papers 1018, Society for Economic Dynamics.
    3. Kondor, Peter, 2004. "The more we know, the less we agree: public announcements and higher-order expectations," LSE Research Online Documents on Economics 24645, London School of Economics and Political Science, LSE Library.
    4. David Kendrick & Hans Amman, 2006. "A Classification System for Economic Stochastic Control Models," Computational Economics, Springer;Society for Computational Economics, vol. 27(4), pages 453-481, June.
    5. Ascari, Guido & Rankin, Neil, 2007. "Perpetual youth and endogenous labor supply: A problem and a possible solution," Journal of Macroeconomics, Elsevier, vol. 29(4), pages 708-723, December.

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    More about this item

    Keywords

    imperfect common; information frictions; Optimal Policy;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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