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Dispersed Information over the Business Cycle: Optimal Fiscal and Monetary Policy

  • Jennifer La'O

    (University of Chicago)

  • George-Marios Angeletos

    (MIT)

We study how the heterogeneity of information impacts the efficiency of the business cycle and the design of optimal fiscal and monetary policy. We do so within a model that features a standard Dixit-Stiglitz demand structure, introduces dispersed private information about the underlying aggregate productivity shock, and allows this information to be imperfectly aggregated through certain prices and macroeconomic indicators. Our key findings are the following: (i) When information is exogenous to the agents' actions, the response of the economy to either fundamentals or noise is efficient along the flexible-price equilibrium. (ii) The endogeneity of learning renders the business cycle inefficient: there is too little learning and too much noise in the business cycle. (iii) Both state-contingent taxes and monetary policy can boost learning over the business cycle. (iv) Typically, this implies that the optimal tax is countercyclical, while the optimal monetary policy is less accommodative than what is consistent with replicating the flexible-price equilibrium. (v) Even if monetary policy were to replicate the flexible-price equilibrium, this would not mean targeting price stability. Rather, the optimal monetary policy has the nominal interest rate increase, and the price level fall, in response to a positive innovation in productivity.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1381.

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Date of creation: 2011
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Handle: RePEc:red:sed011:1381
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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