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Demand Shocks and Monetary Policy

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  • Guido Lorenzoni

    () (Department of Economics, MIT)

Abstract

This paper studies the effects of monetary policy in a model with demand shocks driven by shifts in consumer expectations. I ask wether monetary policy can offset these aggregate demand disturbances and wether this offsetting is socially desirable. I consider an environment with dispersed information and two aggregate shocks: a fundamental shock which affects potential output (a productivity shock), and a demand shock which affects aggregate spending but not potential output (a shock to public beliefs). Neither the central bank nor any individual agent can distinguish the two shocks, when they hit the economy. In this environment I show three results: (1) despite the lack of superior information, an appropriate policy rule can change the economy responses to the two shocks; (2) an appropriate policy rule can achieve full aggregate stabilization, i.e. zero output gap; (3) full stabilization is not desirable, that is, there is an optimal degree of accommodation of aggregate demand shocks.

Suggested Citation

  • Guido Lorenzoni, 2006. "Demand Shocks and Monetary Policy," Computing in Economics and Finance 2006 524, Society for Computational Economics.
  • Handle: RePEc:sce:scecfa:524
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    Cited by:

    1. Antonella Tutino, 2008. "The rigidity of choice: Lifecycle savings with information-processing limits," Finance and Economics Discussion Series 2008-62, Board of Governors of the Federal Reserve System (U.S.).
    2. University of California & Giacomo Rondina, 2008. "Incomplete Information and Informative Pricing: Theory and Application," 2008 Meeting Papers 981, Society for Economic Dynamics.
    3. Guido Lorenzoni, 2009. "A Theory of Demand Shocks," American Economic Review, American Economic Association, vol. 99(5), pages 2050-2084, December.

    More about this item

    Keywords

    Optimal monetary policy; consumer sentiment; imperfect information;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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