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Optimal Monetary Policy with Imperfect Common Knowledge

  • Adam, Klaus

We study optimal nominal demand policy in an economy with monopolistic competition and flexible prices when firms have imperfect common knowledge about the shocks hitting the economy. Parametrizing firms' information imperfections by a (Shannon) capacity parameter that constrains the amount of information flowing to each firm, we study how policy that minimizes a quadratic objective in output and prices depends on this parameter. When price setting decisions of firms are strategic complements, for a large range of capacity values optimal policy nominally accommodates mark-up shocks in the short-run. This finding is robust to the policy maker observing shocks imperfectly or being uncertain about firms' capacity parameter. With persistent mark-up shocks accommodation may increase in the medium term, but decreases in the long-run thereby generating a hump-shaped price response and a slow reduction in output. Instead, when prices are strategic substitutes, policy tends to react restrictively to mark-up shocks. However, rational expectations equilibria may then not exist with small amounts of imperfect common knowledge.

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Paper provided by Center for Financial Studies (CFS) in its series CFS Working Paper Series with number 2003/12.

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Date of creation: 2003
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Handle: RePEc:zbw:cfswop:200312
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  1. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-34, June.
  2. Mackowiak, Bartosz Adam & Wiederholt, Mirko, 2007. "Optimal Sticky Prices under Rational Inattention," CEPR Discussion Papers 6243, C.E.P.R. Discussion Papers.
  3. Jeffery Amato & Hyun Song Shin, 2003. "Public and Private Information in Monetary Policy Models," Levine's Bibliography 666156000000000092, UCLA Department of Economics.
  4. Laurence Ball & N. Gregory Mankiw & Ricardo Reis, 2003. "Monetary Policy for Inattentive Economies," NBER Working Papers 9491, National Bureau of Economic Research, Inc.
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  9. Woodford Michael, 2002. "Inflation Stabilization and Welfare," The B.E. Journal of Macroeconomics, De Gruyter, vol. 2(1), pages 1-53, February.
  10. Pearlman, Joseph, 1986. "Diverse information and rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 10(1-2), pages 333-338, June.
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  12. Stephen Morris & Hyun Song Shin, 2000. "Global Games: Theory and Applications," Cowles Foundation Discussion Papers 1275R, Cowles Foundation for Research in Economics, Yale University, revised Aug 2001.
  13. Svensson, Lars E. O. & Woodford, Michael, 2004. "Indicator variables for optimal policy under asymmetric information," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 661-690, January.
  14. Binder, Michael & Pesaran, M Hashem, 1998. "Decision Making in the Presence of Heterogeneous Information and Social Interactions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 1027-52, November.
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  16. Nimark, Kristoffer P., 2005. "Calvo pricing and imperfect common knowledge: a forward looking model of rational inflation inertia," Working Paper Series 0474, European Central Bank.
  17. Christian Hellwig, 2002. "Public Announcements, Adjustment Delays, and the Business Cycle (November 2002)," UCLA Economics Online Papers 208, UCLA Department of Economics.
  18. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
  19. Townsend, Robert M, 1983. "Forecasting the Forecasts of Others," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 546-88, August.
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