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Rationally Confused: Persistent Responses to Transitory Shocks

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  • Hassan Afrouzi

    (Columbia University)

Abstract

In an analytical framework, we study how an economy with rationally inatten- tive firms responds to supply and demand shocks. Firms optimally choose to ignore the nature of shocks in favor of having a better estimate of how those shocks affect their prices. As a result, in our economy, when firms get signals that they should increase their price, they are confused about whether the underlying shock is a positive demand shock or a negative supply shock. This has significant implications for monetary policy: we prove that if monetary policy shocks are not persistent enough, every expansion caused by a positive policy shock will lead to a recession as firms would interpret it as a negative supply shock. This favors policies such as interest rate smoothing.

Suggested Citation

  • Hassan Afrouzi, 2019. "Rationally Confused: Persistent Responses to Transitory Shocks," 2019 Meeting Papers 1467, Society for Economic Dynamics.
    • Handle: RePEc:red:sed019:1467
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    References listed on IDEAS

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    1. Olivier Coibion & Yuriy Gorodnichenko & Saten Kumar, 2018. "How Do Firms Form Their Expectations? New Survey Evidence," American Economic Review, American Economic Association, vol. 108(9), pages 2671-2713, September.
    2. Saten Kumar & Hassan Afrouzi & Olivier Coibion & Yuriy Gorodnichenko, 2015. "Inflation Targeting Does Not Anchor Inflation Expectations: Evidence from Firms in New Zealand," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 46(2 (Fall)), pages 151-225.
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