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Public's Inflation Expectations and Monetary Policy

  • Leonardo Melosi

    (London Business School)

The paper develops a DSGE model where monetary policy propagates by affecting and coordinating price setters' expectations. Price setters face costs of price adjustment and do not observe the history of technology, monetary, and preference shocks. They form expectations about the evolution of their nominal marginal costs observing their idiosyncratic productivity, which is correlated with the aggregate productivity, last period's output and inflation, and the interest rate set by the central bank according to a Taylor rule. The model is estimated through likelihood methods on a U.S. data set including the Survey of Professional Forecasters as a measure of price setters' expectations. The transmission channel based on price-setters' expectations is found to account for the following three empirical facts that have been documented by the VAR literature: (i) the delayed and persistent effects of monetary shocks on inflation with associated sluggish response of real output; (ii) the price puzzle; (iii) the disappearance of the price puzzle after the 1970s. Structural policies of disinflation, such as the introduction of an "inflation targeting", need to be backed up by a perfect commitment device to succeed.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1151.

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Date of creation: 2011
Date of revision:
Handle: RePEc:red:sed011:1151
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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  1. Peter J. Klenow & Oleksiy Kryvtsov, 2007. "State-Dependent or Time-Dependent Pricing: Does It Matter for Recent U.S. Inflation?," Discussion Papers 07-007, Stanford Institute for Economic Policy Research.
  2. Adam, Klaus, 2004. "Optimal Monetary Policy with Imperfect Common Knowledge," CEPR Discussion Papers 4594, C.E.P.R. Discussion Papers.
  3. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc.
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  8. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  9. Kristoffer Nimark, 2007. "Dynamic Pricing and Imperfect Common Knowledge," RBA Research Discussion Papers rdp2007-12, Reserve Bank of Australia.
  10. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, Oxford University Press, vol. 123(4), pages 1415-1464.
  11. Yuriy Gorodnichenko, 2008. "Endogenous information, menu costs and inflation persistence," NBER Working Papers 14184, National Bureau of Economic Research, Inc.
  12. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  13. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  14. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, December.
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