Optimal monetary policy with uncertain fundamentals and dispersed information

Guido Lorenzoni*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

39 Scopus citations

Abstract

This paper studies optimal monetary policy in a model where aggregate fluctuations are driven by the private sector's uncertainty about the economy's fundamentals. Information on aggregate productivity is dispersed across agents and there are two aggregate shocks: a standard productivity shock and a " noise shock" affecting public beliefs about aggregate productivity. Neither the central bank nor individual agents can distinguish the two shocks when they are realized. Despite the lack of superior information, monetary policy can affect the economy's relative response to the two shocks. As time passes, better information on past fundamentals becomes available. The central bank can then adopt a backward-looking policy rule, based on more precise information about past shocks. By announcing its response to future information, the central bank can influence the expected real interest rate faced by forward-looking consumers with different beliefs and thus affect the equilibrium allocation. If the announced future response is sufficiently aggressive, the central bank can completely eliminate the effect of noise shocks. However, this policy is typically suboptimal, as it leads to an excessively compressed distribution of relative prices. The optimal monetary policy balances the benefits of aggregate stabilization with the costs in terms of cross-sectional efficiency.

Original languageEnglish (US)
Pages (from-to)305-338
Number of pages34
JournalReview of Economic Studies
Volume77
Issue number1
DOIs
StatePublished - Jan 1 2010

ASJC Scopus subject areas

  • Economics and Econometrics

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