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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
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Handle: RePEc:red:sed011:1151
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  1. Peter J. Klenow & Oleksiy Kryvtsov, 2005. "State-Dependent or Time-Dependent Pricing: Does it Matter for Recent U.S. Inflation?," NBER Working Papers 11043, National Bureau of Economic Research, Inc.
  2. Efrem Castelnuovo & Paolo Surico, 2010. "Monetary Policy, Inflation Expectations and The Price Puzzle," Economic Journal, Royal Economic Society, vol. 120(549), pages 1262-1283, December.
  3. Klaus Adam, 2004. "Optimal Monetary Policy with Imperfect Common Knowledge," DNB Staff Reports (discontinued) 116, Netherlands Central Bank.
  4. Luigi Paciello, 2009. "Monetary Policy and Price Responsiveness to Aggregate Shocks under Rational Inattention," EIEF Working Papers Series 0916, Einaudi Institute for Economics and Finance (EIEF), revised Sep 2011.
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  9. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, June.
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  12. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  13. Mirko Wiederholt, 2010. "rational inattention," The New Palgrave Dictionary of Economics, Palgrave Macmillan.
  14. Klenow, Peter J. & Malin, Benjamin A., 2010. "Microeconomic Evidence on Price-Setting," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 6, pages 231-284 Elsevier.
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