Demand Shocks and Monetary Policy
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.
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